Honorable Margaret Richardson
Commissioner
Internal Revenue Service
11th & Constitution Ave. N.W.
Room 3000
Washington, D.C, 20224
re: CC:DOM:CORP:R (IA-26-94)
Qualified Small Business Stock[PDF File}
Dear Commissioner Richardson:
The following comments are submitted regarding proposed amendments to the Income Tax Regulations related to the tax treatment of qualified small business stock (26 USC §1202). These comments are submitted pursuant to section 7805(f) of the Internal Revenue Code (26 U.S.C. §7805(f)). In addition, we hereby request the opportunity to present oral comments at the hearing currently scheduled for October 4, 1996. These comments will serve as an outline for my remarks. §
The Office of Advocacy commends the U.S. Treasury Department and the Internal Revenue Service (IRS) for proposing these additions which would make §1202 more useful to qualifying businesses. We strongly support the proposed rule.
Redemption and §1202 Stock
The Omnibus Budget Reconciliation Act of 1993 OBRA provided that investors in certain qualifying small businesses could exclude from income 50% of the gain they realized on such stock under certain conditions. In order to ensure that the incentive supported the policy of stimulating new, long term investment in small businesses and did not merely supplant existing investment, certain restrictions were enumerated. "New investment" is critically important because this is the kind of investment that fuels growth in small businesses. Simply trading an existing investment for another in the stock market or between parties provides no added benefit to a small business that needs capital.
The restrictions contained in §1202 disqualified the company's stock from the benefits of the incentive if 1) the company redeemed existing stock within 2 years of the issuance of new stock to the shareholder (or a related person) from whom the stock was redeemed; or 2) if the company redeemed, in the aggregate, more than 5% of its existing stock within a year of issuing new stock it seeks to qualify.
Congress intended to limit the benefit of the exclusion to new investment; to make sure investors did not turn "unqualified investments" into "qualified" investments by redeeming or trading their stock back and forth. The result, however, was to make potential investors wary of the possibility that the stock could be disqualified by events beyond the investors' control, e.g. redemption by the company. Redemptions and repurchases are commonplace in business and in most instances reflect good business judgement. Thus, these investments were far less attractive because they involved that extra element of disqualification risk.
Proposed Regulations
The proposed regulations, we feel, will eliminate much of the uncertainty surrounding the redemption clause. Under the proposed regulations, for example, the company is permitted to make de minimums purchases (less than $10,000 or 2 percent of the value of the stock held by the taxpayer) without risking the special tax status. Transfers of shares to an employee by a shareholder in connection to the employees service for the company likewise are not treated as repurchases and so will not disqualify the stock. Finally, repurchases which are made for a number of legitimate business purposes listed in the regulations are also disregarded and therefore will not disqualify the stock. The list includes termination by the corporation, death, disability or mental incompetency. By eliminating the uncertainty, §1202 will become much more attractive to investors and we strongly support the higher level of long term small business investment this will attract.
Divorce
We would recommend that repurchases which are brought about by a divorce should be included (or at least analyzed) by the IRS as another exception under section (d) of the new regulations. We envision a situation where a husband and wife with a few other investors, start up a business with each holding stock. The wife, for example, may not be listed as an employee or an officer but she is an active participant with a vested interest in the success of the business if some of the stock is in her name. If a divorce should occur, the situation might warrant a clean break, with the wife leaving the corporate "family" in much the same way as a terminated employee would. The company should have the option to repurchase stock without the shareholders losing the tax break on the fair market gains on the stock.
Additional Study Requested on Use of §1202
We urge the IRS and Treasury to analyze the current use of §1202. We believe such a study would determine (as the anecdotal evidence seems to indicate) that very few businesses actually benefit from this provision; that is, few investors are persuaded by §1202 as currently written to make long term investments in qualifying small businesses. If so, the worthy policy goal of this provision, to encourage long term investment, has been entirely frustrated and alternatives need to be considered by the IRS and Congress. We would be happy to assist in this effort in any way.
If the Office of Advocacy can be of assistance to you with regard to these comments or the hearing, please feel free to contact us at 202-205-6533.
Sincerely,
Jere W. Glover
Chief Counsel
Russell Orban
Asst. Chief Counsel