Deferral of Gain from the Sale of an Investment in the Small

Business Sector

Under current law, gain from sale of an equity interest in a small business are taxed at the time of the sale as a capital gain. Thus, the tax treatment for sales of investments in successful small businesses is the same as that for gains from sales of investments in large businesses. The risks associated with the two types of investments, however, are quite different. Given the same tax treatment upon ultimate disposition of an investment, a potential investor will obviously choose the least risky among investment alternatives. This discourages investors from committing their savings to the small business sector.

The objective of the small business tax reform program recommended in this report is to defer tax on income derived from investment in the small business sector until it is permanently withdrawn (see Chapter 7). Consistent with this objective, sale of an investment in a profitable small business operation should not be a taxable event if the proceeds are reinvested in small business.

Accordingly, is is recommended that gain from the sale of an equity interest in an SBE, MBE, SMIC or SBE Bonds be deferred if the proceeds from the sale are reinvested within one year in an equity interest in an SBE, MBE, SBIC or in SBE Bonds. Allowing gain from sale of any one of these investments to qualify for tax deferral by timely reinvestment in the same of any other of these small business investments vehicles permits considerable flexibility in choosing reinvestment opportunities. In addition, the possibility of tax-free "rollover" of SBE Bonds by utilization of this procedure should promote their popularity as an investment.

Consistent with the philosophy that tax should be imposed when

investment is permanently withdrawn from the small business sector, gain would be taxable upon the sale of qualifying equity interests or SBE Bonds when no reinvestment in qualifying property is made within one year.

The mechanics of this deferral technique are familiar, being similar 24 to those for deferral of gain from the sale of a personal residence of gain 25

from an involuntary conversion.

Example: A owns an equity interest in an SBE which cost him $30,000.
He sells the interest for $70,000, thereby producing a gain of
$40,000. Within the year he purchases SBE Bonds in the amount of
$70,000. Since the entire proceeds of the sale are reinvested in a
qualifying small business investment, the $40,000 gain is not taxable
in the current year. The tax basis for the bonds is $30,000, the same
as A's tax basis for his original equity interest. During the next
year, A decides to sell the SBE Bonds and invest the proceeds in the
stock of an SBIC. The gain from the sale, $40,000 ($70,000 proceeds
less $30,000 basis), is further deferred because there is a qualifying
reinvestment. The tax basis for the SBIC stock is $30,000, the same
as the basis for the SBE Bonds. In the following year, the stock of the
SBIC is sold for $100,000, and the proceeds are reinvested in General
Motors stock. Because General Motors does not qualify as an SBE, MBE
or SBIC, the gain from the sale, $70,000 ($100,000 proceeds less
$30,000 basis for the SBIC stock) is subjected to tax.

CHAPTER 10

FINANCIAL SECURITY FOR THE ENTREPRENEUR AND HIS FAMILY

THE PROBLEM OF SMALL BUSINESS INDEPENDENCE

The primary purpose of engaging in any business activity is to earn a living sufficient to support the entrepreneur and his family. The rewards of the business effort must not only be adequate to provide for these needs while actively operating the business, but must also be adequate to assure financial security during the entrepreneur's retirement. Further, the business must provide for the security of an entrepreneur's family after his death. The tax law can be 1 a major obstacle to accomplishing these financial security goals. Often, after years of successful business activity, the entrepreneur is forced to sell his business to sustain his family after retirement Estates of deceased entrepreneurs

are often faced with the necessity of selling a business to pay the estate tax. The most probable buyer for a business in either of these circumstances is a larger competitor. Thus, the problem of financial security for the entrepreneur and the problem of business concentration are closely related.

Important objectives of tax reform for small business are to promote both financial security and small business independence. To accomplish these objectives the law must be modified to:

• Permit an entrepreneur to accumulate funds to provide for himself

O

Impose the estate tax in such a way as to facilitate the transfer

of a small business to family members so that they are encouraged to

continue its operation;

Encourage the sale of a small business to an independent entrepreneur

rather than to a larger competitor if the business must be sold;

• Encourage large enterprises to return appropriate segments of their

operations to the small business sector.

Retirement Security for the Small Business Owner

The objective of existing tax provisions for retirement plans is to create a fund which consists of untaxed dollars, to be withdrawn after retirement for the support of the employee or self-employed business operator. This is accomplished by allowing a current tax deduction for contributions to the plan, permitting. these contributions to accumulate tax-free income during the period between contribution and withdrawal, and imposing tax when the funds are eventually withdrawn.

The hearings leading to the enactment of the widely publicized Pension Reform Act of 1976 (ERISA brought to the attention of the public the inadequacies of existing private tax-exempt retirement plan opportunities. These hearings also highlighted the importance of retirement plans to the peace-of-mind and financial security of the average small businessperson.

Unfortunately, in an attempt to correct the inadequacies and to prevent existing abuses resulting from the system, the legislation, as enacted, adds additional complexity of the law. The result is that:

• The creation, administration and maintenance of a qualified (tax-exempt)

pension or profit-sharing plan is complex and expensive;

2/ P.L. 93-406, 93rd Congress, 2nd Session, September 2, 1974

The benefits available for the beneficiaries of the plan

depend not on their economic needs, but on the legal form

As a result, the small businessperson frequently concludes that he must devote a disproportionate amount of his assets and energies to creation and maintenance of a retirement plan. In failing to establish such a plan, he often does not provide for his retirement security.

A frequent complaint is that retirement plan opportunities available to corporate businesses are far more generous than corresponding opportunities available for unincorporated businesses. Corporate retirement plans allow larger tax deductions for current contributions as well as allowing deductions for

past funding, carryovers and integration with Social Security. Under the selfemployed plan (H.R. 10 Plan) available to unincorporated businesses, the

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maximum deduction allowed is the lesser of $7,500 or 15% of earned income. The Individual Retirement Account, available for taxpayers not covered under any 6

other plan, is even more restrictive. The maximum deduction for contributions

is the lesser of 15% of earned income or $1500 (or $1,750 if the spouse is

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If a defined benefit plan is adopted, the amount could be
higher. IRC Section 401 (j) (6)

IRC Section 408