You will have noticed that the Fox News word for rich individuals is "small business", or "small business job creators". Unfortunately the Obama administration, which should know better, seems to be falling for this one. The White House's latest policy initiative is to help the middle class by making it possible for billionaires to pay no tax at all.
To follow this one, you need to bear with a little tax talk. The tax bill that went through at the end of 2010 included two relevant Administration initiatives. One allowed business to, in general, take an immediate deduction for assets they purchase through the end of 2011. The other provided that any gain on the sale of "small business stock" would be completely tax free for stock investments made by the end of 2011. OK, that sounds plausible. If some little guy starts a small business now, makes it successful, and then sells out, they get to tell the IRS to go away, giving them more incentive to take that risk now, though frankly if I had an idea that I thought would earn me $10 million I don't think I'd drop it just out of fear of being taxed on that gain..
But what is a qualifying "small business"? It is a corporation with assets, at the time the stock is issued, of less than $50,000,000. $50,000,000 seems high to begin with, but there is more. The limit is not on an asset value of $50,000,000. It keys off of asset tax basis of that amount. What you need to know about tax basis here is that it is reduced for any deduction you have taken for your investment in the asset. Remember now, for assets acquired in 2011, you get to take a deduction for the whole investment right now. That means that the tax basis of those assets will be zero. So, someone can put a billion dollars into a corporation, buy assets, take a deduction for $950 million, and it will still be "small business" stock.
So today the White House issued the following announcement:
Administration Will Propose Permanent Elimination of the Capital Gains Tax on Certain Small Business Stock: The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 provides a 100-percent exclusion from tax for capital gains realized on the sale of certain small business stock held for more than five years. The amount of gain eligible for the exclusion is limited to the greater of $10 million or ten times the taxpayer's basis in the stock. This provision applies to qualified small business stock issued after December 31, 2010, and before January 1, 2012. The Administration's FY12 budget proposal would make this provision permanent, increasing private sector investment in small businesses.
Now, the other thing you need to know about basis is that if you use a billion dollars to buy stock of a corporation, and that corporation buys assets and takes a deduction for $950,000,000, your basis in the stock is still a billion dollars. Under the "small business" provision, you can completely avoid tax on gain of up to ten times that basis amount, so gain of up to ten billion on a billion dollar investment. When most of us think of small business, we think of the corner store, not Warren Buffet making ten billion dollars and paying zero tax on it.
This country already suffers from a huge overconcentration of wealth, which is bad for the economy and bad for democracy. So, I have a problem with this provision from that point of view. Still, I could almost live with it if I truly believed that the rich folk investing in that billion dollar "small business" would really be innovators launching a new idea. But we have all seen people make a fortune in various ways that contribute nothing to society, and those people will be just as tax free under this proposal as the young Thomas Edisons of the world. (As one example, though this would be limited to a "mere" $500 million of exempt gain, the provision would apply to stock in a U.S. corporation that built a factory in China that replaced a U.S. production plant.) The Administration has other proposals more tailored to helping actual little folk with limited capital to start up a business. If we are going to steer money towards this proposal rather than those, let's at least be honest about the trade-offs. Don't call it "small business" stock. Call it venture capital, and admit that we have a system where we think it is OK that, as Leona Helmsley famously said, "only little people pay taxes."
Updated by Shared Growth at Mon May 09, 2011 at 11:19 PM PDT
An addendum for the commenters, extracted from a report on the may 7 ABA tax section meeting:
"The gain exclusion provision provides an opportunity for noncorporate taxpayers to have 100 percent of the gain on the sale of their QSBS excluded from federal income tax and alternative minimum tax. In general, QSBS stock is original-issuance stock of a C corporation whose aggregate gross assets at the time of formation are valued at less than $50 million.
The stock must be acquired between September 27, 2010, and December 31, 2011, and must be held for more than five years before it is sold. A taxpayer may have its amount of eligible excluded gain limited in some cases.
David B. Strong, a partner at Holme Roberts & Owen LLP, said he has seen many venture capital funds and private equity partnerships take advantage of the provision.
Under IT&A's suggested reading of the statute, which Strong endorsed and described as an "interesting feature" of the provision, a taxpayer that is holding two blocks of stock -- one with low basis and another with high basis -- can sell both blocks in the same year and use the basis limitation from the high-basis block to effectively offset some of the gain in the low-basis block. As for the sale of two blocks of stock in different years, Alexander remarked that his colleagues at IT&A have not addressed how the statute operates in such a case.
Elliot Freier, an attorney with Irell & Manella LLP, said that because the $50 million test is a basis test and not a fair market value test, "you can pay $50 million in and burn it off, take in another $50 million, burn it off, and keep running this thing for quite a while before [section] 1202 doesn't apply anymore."