Big Tax Breaks for Small-Business Investors

President Clinton’s newly passed tax law could prove to be very generous for some investors, experts say.

It provides two new tax breaks for those who pour money into certain small businesses. It also turns an on-again, off-again tax shelter on permanently. It retools an abused government-sponsored investment program to better gear it to the serious investors who could profit from it. And it makes certain tax-favored investments, such as municipal bonds, variable annuities and 401(k) plans, even more attractive for well-heeled investors.

“These things are very, very important,” says Steven Shaul, president of Smash by O.G., a Los Angeles-based manufacturer so enthralled by the small-business tax breaks that it put up billboard-size thanks to President Clinton in a sign off the 710 Freeway. Shaul believes his small company will have a better chance of attracting investors thanks to the new law.

On the flip side, the law also creates several land mines for the unwary.

For example, if you want the tax breaks, you can’t invest in just any small business, notes Gregg Ritchie, partner in the financial planning group of KPMG Peat Marwick. Only certain types of small businesses qualify--and the businesses that qualify are arguably among the most risky for investors.

The tax law also eliminates a practice called conversion that allowed savvy investors to report capital gains instead of ordinary income by entering into complicated agreements.

“Nobody can do investment planning anymore without an Internal Revenue Code on their laps,” says Philip J. Holthouse, partner at Holthouse Carlin & Van Trigt in Los Angeles.

Nonetheless, those who know the rules can reap substantial benefits from the newly passed law.

The most generous breaks are for investors in small businesses, and they come in two varieties.

The first allows those who buy and hold shares in manufacturing businesses with less than $50 million in gross assets to shelter 50% of their capital gains from taxation. In other words, if you had a $100,000 capital gain, you’d normally owe $28,000 in federal tax. But now, if you meet the requirements of the new law, you would only pay $14,000 in tax.

The caveats: You can’t get the breaks when you invest in a service firm or financial institution. They’re only for companies that use “at least 80% of their assets in a qualified trade or business”--essentially a manufacturing firm, says Harvey Gettleson, partner at Ernst & Young in Los Angeles.

You’ve got to hold the investment for at least five years. And the tax exclusion is also limited to the lesser of 10 times your investment in the stock or $10 million.

The second break for investors in small businesses works something like residential real estate rollover rules. If you sell stock in an exchange-listed company at a gain, you can defer paying tax on the profit by rolling the proceeds from the sale into a “specialized small business investment company.”

Consider someone who bought 1,000 shares in XYZ company several years ago for $10 a share. The shares are now worth $30 and the investor wants to sell. But that $20,000 profit would trigger a $5,600 tax bill, so he decides to roll the proceeds into a specialized small business investment company--a particular type of investment company that’s licensed by the Small Business Administration. (SSBICs are somewhat similar to Real Estate Investment Trusts, or REITs, which pool investor assets to buy income-producing properties. However, in this case, the investor funds finance “disadvantaged” small businesses.)

This investor doesn’t have to pay tax on his XYZ gain until he sells the shares in the SSBIC. But he can’t defer more than $50,000 in gains annually or more than $500,000 in his lifetime.

There’s one other catch: He’s got to roll all of the sale proceeds into the SSBIC, not just his gain. If he doesn’t want to invest a full $30,000 in an SSBIC, he’ll pay tax on the amount that wasn’t rolled over. He also must roll over his gain within 60 days.

Real estate investors also get two breaks to choose from.

First, there’s low-income housing tax credits. These credits have been around for several years. However, until now, the low-income program was seemingly always threatened with extinction. Indeed, it expired several times only to be renewed at the last hour--or even retroactively--for relatively brief periods. Clinton’s plan makes the low-income program permanent.

The tax breaks can be generous. The downside is that the industry has a spotty track record. While some of these deals may prove to be good investments, some investment organizers have abused the program by setting up the deals through limited partnerships that allow the organizers and salespeople to take out big fees--up to 35% of your investment.

Then they tie up your principal for a decade or more, with no guarantee you’ll get your principal back. If you duck out early, the tax breaks are shot.

The second break allows high-income individuals who spend more than half their time and at least 750 hours a year in the real estate business to deduct losses from their real estate rental properties against ordinary income. Most wealthy people--those who earn upward of $100,000 annually--can deduct these losses only against so-called passive income from other activities, such as real estate partnerships, for which they are not actively engaged.

Meanwhile, there’s good news and bad news for people who have invested in Federal Communications Commission airwave lotteries. If your lottery application was accepted before July 26, the FCC will hold a lottery for that market and product.

But after these lotteries are through, airwave lotteries are probably gone forever. The bill allows the FCC to auction off airwaves rather than raffle them, and government officials believe that from now on, that’s what will be done.

Since there were a few lotteries already in progress, they will be completed. There will be a drawing Sept. 15, for example, for nine interactive-TV franchises.

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Note to seniors: Because of tremendous confusion about the new Social Security tax, Kathy Kristof has prepared a booklet and work sheet that helps seniors determine whether the new tax will affect them and what they can do about it.

For a copy, please send a written request with your name, address and a check or money order for $2.95, payable to the Los Angeles Times. (The price includes postage, handling and sales tax.) Mail requests to Retirees’ Tax Tips, P.O. Box 60395, Los Angeles, Calif. 90052. Please allow two to three weeks for delivery.