Viard On the Margin Feb 2012

Download PDF Intense debate continues over the appropriate level of marginal income tax rates, particularly as policymakers consider whether to extend part or all of the 2001 and 2003 tax cuts, which are currently scheduled to expire at the end of 2012. Unfortunately, much of this debate has been misdirected. Many supporters of marginal tax rate reduction have ignored its real advantages and instead advanced invalid arguments. Their strategy undermines the effort to lower marginal tax rates, and it promotes the spread of other, less desirable, forms of tax reduction.

The real economic case for marginal rate reduction is that it alleviates the work, saving, and investment disincentives associated with income taxation. Rate reduction allows a greater range of mutually beneficial transactions involving work, saving, and investment to occur throughout the economy. Of course, the feasible and desirable scope of marginal tax rate reduction depends on budgetary and distributional concerns, which are important issues in light of the ongoing increase in Medicare, Medicaid, and Social Security spending and the rise in inequality during the last few decades.

A key advantage of marginal rate reduction is that it does not single out particular sectors of the economy for favorable tax treatment over other sectors. Yet, supporters of rate reduction often advocate it on the ground that it helps particular sectors. The use of those arguments undermines the case for rate reduction. It also creates a political opening for policies that are more directly targeted to help the particular sectors, even though those policies are likely to be economically inferior to marginal rate reduction. Targeting particular sectors for tax relief tilts the economic playing field and misallocates economic resources, unless the targeted sector is initially taxed more heavily than others, in which case the targeting actually helps level the playing field. Targeted policies also tend to create complexity.

"In the current debate, the focus on small business has played a pernicious role." - Alan D. Viard

In the current debate, the focus on small business has played a pernicious role. Supporters of extension of the 2001 and 2003 tax cuts have often couched the case for extension in terms of helping small business. That strategy has weakened the case for marginal rate reduction and encouraged the rise of alternative policies that are inefficient and complex.

The small business focus adopted by many supporters of rate reduction has allowed opponents to correctly point out that rate reduction is not well targeted to specifically help small business and has spared them from confronting the real advantages of rate reduction. For example, the individual income tax rate reductions that President Obama proposes to end (those applicable to incomes exceeding $200,000 for singles and $250,000 for couples) lower marginal tax rates on roughly half of the income generated by passthrough businesses, thereby significantly easing investment disincentives and offering sizable economic gains. As opponents of rate reduction have pointed out, however, many of the affected passthrough businesses are relatively large, and many of their owners would not be described as businesspeople in a properly conducted occupational census. Although these facts have no tax policy relevance, they invalidate supporters' misdirected small business arguments.¹ In the end, the focus on small business results in the real economic advantages of the rate reduction -- the reduction of investment disincentives at companies of all sizes -- being overlooked.

In this article, I focus on the other major adverse consequence of the misdirected focus on small business. This focus has encouraged opponents to counter calls for rate reduction by advancing policies that, unlike rate reduction, are targeted to small business. Obama has repeatedly adopted this strategy, promoting his own targeted tax preferences for small business as an alternative to rate reduction. Unfortunately, these targeted measures are often economically inefficient and complex. To illustrate this point, I examine in depth the section 1202 small business stock exclusion, a provision that Obama has repeatedly moved to expand.

The History of Section 1202

The section 1202 exclusion for capital gains on qualified small business stock was signed into law by President Clinton in 1993.² The provision owes its existence to the efforts of another Arkansas Democrat, then-Senator Dale Bumpers, who chaired the Senate's Small Business Committee.

Under section 1202(c)(1), the exclusion applies only to stock acquired on or after August 11, 1993. Under section 1202(a)(1) and (b)(2), the stock also must be held for at least five years and a day, so no sales qualifying for the tax break could occur until August 12, 1998. Under section 1202(c)(1)(B), the stock must be acquired by the taxpayer at its original issuance by the business.³ As explained below, the stock must be issued by a business that is small, as measured by its gross assets.

The permanent rules in section 1202(a)(1) allow half the gain on qualified small business stock to be excluded from taxable income. As discussed below, Congress and the president have enacted more generous treatment for some recently issued stock.⁴ Under section 1(h)(4)(A)(ii), the included portion of the gain is "28-percent rate gain." Exempting half the gain and taxing the remaining half at 28 percent results in an effective tax rate of 14 percent.

Under section 1202(b), the amount of gain from for the stock of a particular corporation for which a taxpayer may claim the preference in any given year is limited to $10 million minus any previous gain from that corporation's stock or, if greater, an amount equal to 10 times the taxpayer basis in the stock.⁵ Gain in excess of that limit cannot be excluded and is not subject to the 28 percent rate.

Section 1045, which was enacted in 1997, allows a tax-free rollover of qualified small business stock that has been held for at least six months.* Other small business stock must be purchased within 60 days, and basis in the acquired stock is reduced by the amount of the excluded gain. The first six months of the holding period also carries over to the replacement small business stock.

So far Obama has signed three laws increasing the generosity of the section 1202 exclusion for recently issued qualified small business stock. First, the stimulus package enacted in February 2009 increased the excludable portion to 75 percent for stock acquired from February 18, 2009, to December 31, 2010, lowering the effective tax rate from 14 to 7 percent.⁶ Note that because of the required holding period, no sales qualifying for this treatment can occur until February 19, 2014.

Then the small business bill enacted in September 2010 increased the excludable portion to 100 percent for stock issued from September 28, 2010, through December 31, 2010, obviously reducing the effective tax rate to zero.⁷ No sale qualifying for the 100 percent exclusion can occur until September 29, 2015. Media reports noted at the time that small businesses were ill-equipped to issue stock in response to this provision, because it was enacted with little advance notice and was scheduled to last only about three months.⁸ That problem largely disappeared in December 2010, however, when the tax compromise package agreed to by Obama and the congressional leadership extended the 100 percent exclusion to apply to stock issued through December 31, 2011.⁹ Those provisions for recently issued stock are set forth in section 1202(a)(3) and (a)(4).

Under current law, the excluded fraction has reverted to the permanent 50 percent value for stock issued on or after January 1, 2012. In his fiscal 2012 budget proposal released in February 2011, however, the president proposed a permanent extension of the 100 percent exclusion.¹⁰

The Obama administration estimates the revenue loss from the permanent extension of the 100 percent exclusion at $5.4 billion in fiscal 2012 through 2021, with the annual revenue loss rising over time as more sales subject to the exclusion occur. The annual loss reaches $2 billion in fiscal 2021.¹¹

The treatment of small business stock gains under the alternative minimum tax, which is set forth in section 57(a)(7), has undergone several changes. Legislation adopted in 1997 required that 42 percent of the gain excluded under the regular income tax be added back under the AMT.¹² The AMT was therefore imposed on 71 percent of the gains, consisting of the half that was subject to regular income tax plus 42 percent of the half excluded from regular tax. Taxing 71 percent of the gain at 28 percent (which is also tax rate also applies to the included portion of small business stock gain under the AMT) yielded an effective AMT tax rate of 19.88 percent.¹³

Legislation adopted in 1998 provided more generous AMT treatment for small business stock acquired on or after January 1, 2001.¹⁴ For that stock, only 28 percent of the excluded gain was added back for AMT purposes, so that 64 percent of the gain (the half included under regular tax plus 28 percent of the half excluded under regular tax) would be subject to AMT, resulting in an effective AMT rate of 17.92 percent.

The 2003 tax cut superseded the 1998 legislation, reducing the portion of the excluded portion added back under the AMT to 7 percent, regardless of whether the stock was acquired before or after January 1, 2001, if the stock was sold on or after May 6, 2003.¹⁵ That rule results in 53.5 percent of the gain being subject to AMT, yielding an effective AMT rate of 14.98 percent. Under current law, the 7 percent AMT addback applies only to sales made through December 31, 2012; for subsequent sales, either the 42 percent addback from the 1997 law or the 28 percent addback from the 1998 law applies, depending on whether or not the stock was acquired before January 1, 2001.

Although the 2009 stimulus law did not directly amend the AMT provisions, it effectively lowered the AMT rate. Recall that the law reduced the portion of the gain included in regular taxable income to 25 percent for stock issued from February 18, 2009, through September 27, 2010. Under the 1997 legislation, 28 percent of the excluded amount is added back for AMT purposes,¹⁶ so the AMT applies to 46 percent of the gain (the 25 percent included under the regular tax plus 28 percent of the other 75 percent), yielding an effective tax rate of 12.88 percent.

The September 2010 and December 2010 laws offered more potent AMT relief by providing that the 100 percent exclusion applies under the AMT as well as under the regular income tax. For stock subject to those laws, the effective tax rate is zero under both tax systems. Obama's proposal would permanently extend the 100 percent AMT exclusion as well as the 100 percent regular income tax exclusion.

The table on the preceding page describes the effective tax rates that apply to capital gains from the sale of qualified small business stock under the regular income tax and the AMT.

How to Think About the Section 1202 Exclusion

Throughout much of its history, section 1202 has offered very small tax savings, because the effective tax rates on qualified small business stock were only slightly lower than the rates applicable to other long-term capital gains. Under both the regular income tax and the AMT, capital gains on stock held more than five years are generally taxed at 20 percent for sales on or before May 5, 2003, 15 percent for sales from May 6, 2003, through December 31, 2012, and 18 percent for sales after 2012 if the stock was acquired in or after 2001 (20 percent if the stock was acquired before 2001).¹⁷

The provisions applicable to recently issued stock, particularly the zero tax rates for stock issued from September 28, 2010, to December 31, 2011, offer more substantial tax savings. It makes little sense, of course, to provide a tax preference that offers few savings, particularly when the preference has complex rules and restrictions, which, as discussed below, this preference does. The zero tax rates are also simpler to administer than the array of exclusion ratios and AMT addback factors that prevailed under prior law. So if the section 1202 exclusion is to be preserved, it may well make sense to adopt the president's proposal to permanently extend the 100 percent exclusion under both the regular tax and the AMT.

But the first question to address is whether the exclusion should exist at all. The Obama administration justifies the proposal for a 100 percent permanent exclusion on the grounds that "making the exclusion permanent would encourage and reward new investment in qualified small business stock."¹⁸ No doubt so. But is there any reason to provide an incentive for this type of investment that does not apply to other investments?

To be fair, the exclusion starts out with one logical feature. Under section 1202(c)(1) and (e)(4), qualified small business stock must be issued by a C corporation chartered in the United States, other than a domestic international sales corporation or former DISC, real estate mortgage investment conduit, regulated investment company, real estate investment trust, or section 936 corporation. This restriction of the preference to equity finance by C corporations makes good economic sense. The reason is that equity-financed investments by C corporations are subject to a second layer of tax under the corporate income tax, while debt-financed investments by C corporations and investments by flow-through businesses do not face that burden. Easing the tax burden on the most heavily taxed portion of investment helps to narrow economic distortions by leveling the playing field. A level playing field allows the market, rather than tax policy, to direct the allocation of economic resources.

To achieve its purpose, of course, the section 1202 exclusion must actually lower the cost of capital. Statistical evidence confirms that the provision has done this. A careful empirical investigation by David Guenther and Michael Willenborg found that the tax savings from the preference were indeed largely captured by the issuing corporation in the form of higher stock prices. Guenther and Willenborg compared the pricing of initial public offerings by small companies that were likely to qualify under section 1202 to the pricing of offerings by larger companies that did not qualify. After controlling for other relevant factors, the researchers found that the former companies showed an increase in the stock price after the preference took effect on August 11, 1993, while the latter group of companies displayed no similar price response. Rough calculations by Guenther and Willenborg indicated that the issuing corporations captured nearly all the tax savings from the exclusion; after paying the higher stock price, the investors reaped little or no net gain.¹⁹

So far, so good. Section 1202 is intended to lower the cost of capital for tax-disadvantaged equity-financed investment by C corporations and it achieves its goal. But things go downhill from here.

The problem is that section 1202 is narrowly targeted. The provision applies to small companies but not to large companies, it applies to companies in some industries but not to companies in other industries, and it applies to the issuance of stock to some purchasers but not to others. Each of these limitations creates economic distortions and tilts the playing field by providing artificial tax advantages to some economic transactions over others.

Moreover, as we will see, these limitations add complexity. The complexity is amplified by the fact that the IRS has not adopted regulations to implement section 1202, except reg. section 1.1202-2, which was adopted in 1997 and addresses only the effects of stock repurchases by the issuing company.²⁰ Mastering the intricate restrictions of this provision is no easy task. Although the Schedule D instructions provide some information about the exclusion, the instructions refer the reader to Publication 550 for more information. That publication, in turn, devotes two pages to the exclusion, but refers taxpayers to section 1202 and reg. section 1.1202-2 for further information.

In contrast to section 1202, the dividend tax cut adopted in 2003 offers a much different and far better way to lower the cost of capital for equity-financed investment by C corporations. The dividend tax cut applies broadly and does not feature the various limitations embedded in section 1202, thereby avoiding the distortions and complexities of the latter provision.²¹

I now describe some of the major limitations imposed by section 1202 and discuss the associated inefficiency and complexity.

The Limitation to Small Business

In 1993 the House Ways and Means Committee justified the original enactment of the exclusion on the following grounds:

The committee believes that targeted relief for investors who risk their funds in new ventures, small businesses, and specialized small business investment companies, will encourage investment in these enterprises. This should encourage the flow of capital to small businesses, many of which have difficulty attracting equity financing.²²

Unfortunately, this economic rationale is unsound. Because of space limitations, I will not repeat here the case for economists' consensus view that tax policy should not favor small companies over large companies. Amy Roden and I reviewed that case in a 2009 article,²³ with citations to an extensive existing literature. Martin Sullivan recently reviewed that case in these pages.²⁴ Businesses of all sizes contribute to economic prosperity. Tax preferences for companies of one size tilt the economic playing field, artificially drawing resources away from companies of other sizes and creating economic inefficiency.

The section 1202 preference is indeed limited to small corporations. Under section 1202(d), the corporation must have had gross assets of $50 million or less at all times from August 10, 1993, through the date on which the stock was issued, and it must continue to have gross assets in that range immediately after the stock issuance. Property is valued at its basis, with property contributed to the corporation treated as having a basis equal to fair market value. All companies under greater-than-50-percent common control are aggregated. Stock and debt held in a greater-than-50-percent subsidiary are disregarded, but the subsidiary's assets are included under a look-through rule.

It is unclear why eligibility is based on gross assets rather than gross receipts (a standard used in several other code provisions) or some other criterion. There also seems to be no specific justification for the selection of $50 million as the upper limit. As Lisa Sergi, Scott Jones, and Mary Kuusisto noted in a 2008 paper, the limit is not indexed for inflation and has remained unchanged since 1993.²⁵ If the limit had been indexed using the formula set forth in section 1(f), it would now be about $80 million.

Sergi, Jones, and Kuusisto also pointed to a problem with the manner in which asset value is measured. Although property is generally valued at basis, which is relatively easy to determine, section 1202(d)(2)(B) provides that property contributed to the corporation is valued at its FMV on the contribution date. Sergi, Jones, and Kuusisto noted that the determination of FMV can be quite difficult when a company's founders contribute patents or other intellectual property to the company, raising the risk that the company will later be found to have exceeded $50 million and that its stockholders will therefore be denied the exclusion. More generally, Sergi, Jones, and Kuusisto noted the record keeping that is required to document compliance with the asset requirement.

A deeper problem is that any tax preference that is limited to small businesses inescapably penalizes the company's growth, as Roden and I emphasized in our 2009 article. In this case, the company is discouraged from acquiring assets that will take it above the $50 million threshold, because any stock subsequently issued by the company will not qualify for the exclusion. Moreover, because property (other than contributed property) is valued at basis, the company may also be deterred from realizing accrued gains on its property.

Any restriction based on company size can be avoided in a number of ways. Accordingly, section 1202(k) specifically authorizes regulations to "prevent the avoidance of the purposes of this section through split-ups, shell corporations, partnerships, or otherwise." To date, no such regulations have been adopted.

But the restriction to small companies is only one of the limitations built into section 1202. A further limitation is that only companies in selected industries can take advantage of the provision.

Limitation to Selected Industries

Section 1202(c)(2) and (e) require that throughout the taxpayer's holding period, the corporation must use at least 80 percent of its assets in the active conduct of one or more qualified trades or businesses.

Under section 1202(e)(3), the following activities are not qualified trades or businesses:

• the performance of personal services in health, law, engineering, architecture, accounting, actuarial sciences, performing arts, consulting, athletics, financial services, brokerage services, or any business whose principal asset is the reputation or skill of its employees;
• banking, insurance, financing, leasing, investing, or any similar business;
• farming, including the raising or harvesting of trees;
• production or extraction of oil or minerals; and
• operating a hotel or motel or any similar business.

It is hard to see much rhyme or reason to this list. Sergi, Jones, and Kuusisto particularly criticize the exclusion of health services. For what it is worth, this list differs from lists of disfavored businesses set forth elsewhere in the code. For example, section 144(a)(8) restricts tax-exempt municipal bond financing for retail food and beverage service facilities, automobile sales or service facilities, facilities that provide recreation or entertainment, private or commercial golf courses, country clubs, massage parlors, tennis clubs, skating facilities, racquet sports facilities, hot tub facilities, suntan facilities, and racetracks. The two lists appear to have little overlap, but I leave as an exercise for the reader the construction of a Venn diagram charting their exact relationship.

The list of disqualified businesses contains several ambiguities. What businesses are "similar" to banking, insurance, finance, investing, and leasing? What businesses have the reputation or skill of employees as their "principal asset"? To date, no regulations have been adopted to clarify these terms.

As stated above, at least 80 percent of the company's assets must be held in the "active conduct" of a qualified business. The statute adopts a number of provisions to supplement this basic rule. Section 1202(e)(2) includes some start-up and research activities as active conduct of a business. Under section 1202(e)(6), assets held as part of the company's "reasonably required working capital needs" are treated as being used in the active conduct of business, as are investment assets that are reasonably expected to be used within two years to finance research or working capital needs. If the corporation has been in existence for two years or more, however, no more than 50 percent of its assets can receive the benefit of the working-capital and investment exceptions. Under section 1202(e)(8), rights to computer software that produces active-business royalty income are treated as active-conduct assets. Section 1202(e)(7) prohibits the company from holding more than 10 percent of its assets in the form of real property not used in the active conduct of business. Also, under section 1202(e)(5), the corporation may not hold more than 10 percent of its assets in the form of portfolio stock, other than portfolio stock that qualifies for the working-capital and investment exceptions.

Recall that for a particular stockholder to claim the exclusion, the company must meet this 80 percent restriction not only when it issues the stock, but also throughout the stockholder's holding period, an interval that must last more than five years and may last considerably longer. If the company violates the restriction at any time before the stockholder sells, the exclusion is lost.

These rules also contain their own ambiguities. For example, section 1202(e)(6) does not specify how the company's "reasonably required working capital needs" are to be determined, and no regulations have been adopted to clarify this question. As one might expect, practitioners tend to look to section 537's reference to the "reasonable needs of the business," as elaborated in reg. section 1.537.

Aside from being limited to small companies in particular industries, the section 1202 exclusion is also limited to selected stockholders.

Limitation to Selected Stockholders

Section 1202(c)(1)(B) generally requires that the taxpayer claiming the exclusion acquire the stock at original issue, either directly or through an underwriter. Section 1202(f) and (h) extend the exclusion to taxpayers who acquired the stock through gift or inheritance or in some tax-free transactions from a stockholder who acquired it at original issue. The stock cannot have been acquired in exchange for stock; it must have been acquired in exchange for money, other property, or services provided to the corporation.

The provision of the exclusion to only the original holder of the issued stock would be less problematic if the restriction were broadly available to all potential stock purchasers. But section 1202 proceeds to impose a number of other limitations.

First, the exclusion is primarily available only to individual stockholders. Under section 1202(a)(1), the exclusion may not be claimed by a stockholder that is a corporation. Section 1202(g) allows owners of flow-through entities that hold the stock to claim the exclusion, but only if the owner held an interest in the flow-through entity throughout the entire period in which the entity held the stock.

Second, the exclusion is available only to long-term holders of the stock. As previously noted, section 1202(a)(1) and (b)(2) require that the stock be held for at least five years and a day. Section 1202(h) provides that for stock acquired through gift or inheritance, the prior holder's holding period is included. If the corporation converts the stock into other stock, the replacement stock continues to qualify and the holding period carries over from the original stock under section 1202(f).

There is no sound economic reason tax policy should artificially promote the sale of stock to those who plan to hold it for an extended period. Of course, once a stockholder acquires stock from a qualified small business, the holding period requirement creates a lock-in effect, discouraging any sale until the requirement has been satisfied.

As with any holding period requirement, steps must be taken to prevent its avoidance. Under section 1202(j), if the taxpayer (or a related party) makes a short sale of property "substantially identical" to the stock or acquires an option to sell that property, the taxpayer is treated as having sold the stock at that time for its FMV. Section 1202(j)(2)(C) specifically authorizes regulations to extend this rule to taxpayers who enter into any other transaction that "substantially reduces the risk of loss" from holding the stock, but no such regulations have been adopted.

Third, the marginal effect of the restriction is denied to large stockholders. As discussed above, section 1202(b) limits the amount of a stockholder's gain that can receive the preferential treatment to $10 million or 10 times basis. Although stockholders realizing larger amounts of gain receive tax savings, they have no marginal incentive to purchase additional stock from the company. There is no economic reason to limit the incentive in this manner.

Conclusion

In its current form, section 1202 is a prime example of distortionary and complex tax policy. It vividly illustrates all the vices of narrowly targeted tax preferences. The best course is to abolish the provision.²⁶

At the risk of stating the obvious, work, saving, and investment disincentives are best alleviated through general reductions in marginal tax rates on work, saving, and investment -- precisely the strategy adopted by the 2001 and 2003 tax cuts. Of course, the feasible and desirable scope of marginal rate reduction depends on budgetary and distributional concerns, which should and will be considered in the debate over whether to extend those tax cuts.

The current tax policy debate has been misdirected because of the unwillingness of supporters of marginal rate reduction to articulate the real economic case for that reduction. Many supporters argue that rate reduction is justified because it will promote the growth of specific sectors, such as small business. Yet, the real case for marginal tax rate reduction is precisely that it does not single out particular sectors for special benefits, but instead reduces tax impediments to mutually beneficial transactions involving work, saving, and investment throughout the economy.

One consequence of these misplaced arguments is that it makes it harder to enact marginal tax rate reductions. For example, when supporters of rate reduction justify it as a way to help small business, opponents of rate reduction are given the opportunity to argue against it on the ground that it is not targeted to benefit small business. The untargeted nature of marginal tax rate reduction, which is actually its greatest economic advantage, then becomes a political obstacle to its adoption.

The other consequence of these misplaced arguments is the proliferation of targeted tax preferences, such as section 1202. If the perceived goal of tax policy is to help small business, provisions like section 1202 are inevitably going to be seen as attractive substitutes for marginal rate reduction. But when the goal of tax policy is seen to be to interfere as little as possible with mutually beneficial transactions involving work, saving, and investment throughout the economy, the advantages of marginal tax rate reduction become clear.

Supporters of marginal rate reduction should begin emphasizing the real economic advantages of those policies. That will help head off targeted distortionary policies such as section 1202. And it will allow an honest debate about the extent of marginal rate reduction that can be adopted, consistent with the nation's budgetary and distributional objectives.

Alan D. Viard is a resident scholar at AEI.

*This article has been updated from an earlier version.

FOOTNOTES

¹ For insightful discussion of this debate, see two recent articles by Martin A. Sullivan: "Should We Raise Tax Rates on Wealthy Employers?" Tax Notes, Sept. 5, 2011, p. 979, Doc 2011-18511 , or 2011 TNT 172-2 ; and "The Myth of Mom-and-Pop Businesses," Tax Notes, Sept. 12, 2011, p. 1085, Doc 2011-18977 , or 2011 TNT 176-1 .

² The Omnibus Budget Reconciliation Act of 1993, P.L. 103-66, section 13113.

³ To limit the preference to new stock issuance, section 1202(c)(3) denies the preference if the corporation repurchased its stock during the two years before the issuance, unless the repurchases do not exceed 5 percent of its aggregate stock outstanding two years before issuance. Reg. section 1.1202-2(b) provides a further de minimis exception to this rule.

⁴ Section 1202(a)(2) allows a 60 percent exclusion for stock issued by some small businesses located in empowerment zones or in the District of Columbia Enterprise Zone. For stock issued from February 18, 2009, through December 31, 2011, this 60 percent exclusion is superseded by the more generous rules adopted by the 2009 and 2010 laws discussed in the text.

⁵ The text of section 1202(b)(1)(B) appears to state that all sales of qualified small business stock (that are acquired from the same small business) made by the taxpayer within a year are aggregated for purposes of applying the 10-times-basis limit. Amy S. Elliott, "IRS Reads 'Interesting Feature' Into Stock Gain Exclusion," Tax Notes, May 16, 2011, p. 688, Doc 2011-9935 , 2011 TNT 90-4 , reports that the IRS has only "tentatively" accepted this interpretation.

⁶ American Recovery and Reinvestment Act of 2009, P.L. 111-5, section 1241.

⁷ Small Business Jobs Act of 2010, P.L. 111-240, section 2011.

⁸ Emily Maltby, "For New Tax Breaks, Act Fast: Law Offers Capital-Gains Relief, But Investors Gripe About Short Time Period," The Wall Street Journal, Sept. 30, 2010, at B5.

⁹ Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312, section 760.

¹⁰ For prior coverage of the proposal, see Drew Pierson, "White House Proposes Making Capital Gains Tax Break Permanent," Tax Notes, Feb. 7, 2011, p. 622, Doc 2011-2134 , or 2011 TNT 21-1 .

¹¹ Treasury, "General Explanations of the Administration's Fiscal Year 2012 Revenue Proposals" (Feb. 2011), Doc 2011-3155 , 2011 TNT 31-21 (fiscal 2012 green book).

¹² Taxpayer Relief Act of 1997, P.L. 105-34, section 311(b)(2).

¹³ OBRA 1993 initially required that half of the excluded amount be added back for purposes of the AMT, but the 1997 legislation described in the text superseded this rule before the first sales of qualified small business stock occurred in 1998.

¹⁴ Internal Revenue Service Restructuring and Reform Act of 1998, P.L. 105-206, section 6005(d)(3).

¹⁵ Jobs and Growth Tax Relief Reconciliation Act of 2003, P.L. 108-27, section 301(b)(3).

¹⁶ Under current law, qualified small business stock issued from February 18, 2009, through September 27, 2010, cannot qualify for the more generous 7 percent addback, because that stock cannot be sold until February 19, 2014, or later, and the 7 percent addback applies only to sales made through December 31, 2012.

¹⁷ When section 1202 was enacted in 1993, larger tax savings were anticipated, because other long-term capital gains then faced a 28 percent tax rate. But that rate was lowered to 20 percent in 1997, before the first sales of qualified small business stock occurred.

¹⁸ Fiscal 2012 green book, supra note 11, at 12.

¹⁹ David A. Guenther and Michael Willenborg, "Capital Gains Tax Rates and the Cost of Capital for Small Business: Evidence from the IPO Market," 53 J. Fin. Econ. 385 (1999).

²⁰ To be clear, this is not the fault of the IRS. The agency is busy adopting guidance to clarify the multitude of other complex and ambiguous tax statutes that Congress has seen fit to enact.

²¹ Even the dividend tax cut is not the ideal way to address this issue. It would be better to directly reduce or eliminate the corporate income tax that produces the disparate burden on equity-financed investment by C corporations. The problem with the dividend tax cut is similar to one of the problems with section 1202, but far less severe: The dividend tax cut applies to some stockholders (taxable American individuals) but not to other stockholders. For further discussion of the merits of providing relief from the corporate tax at the firm level, see Rosanne Altshuler et al., "Capital Income Taxation and Progressivity in a Global Economy," 30 Va. Tax. Rev. 355 (2010); Jane Gravelle and Thomas L. Hungerford, "Corporate Tax Reform: Issues for Congress," Congressional Research Service report RL34229, at 29 (Oct. 31, 2007), Doc 2007-24528 , 2007 TNT 214-37 ; Harry Grubert and Rosanne Altshuler, "Corporate Taxes in the World Economy: Reforming the Taxation of Cross-Border Income," in Fundamental Tax Reform: Issues, Choices, and Implications, at 348-349 (2008, eds. John W. Diamond and George Zodrow); and Sullivan, "Corporate Tax Reform: Time to Think Outside the Box," Tax Notes, Mar. 28, 2011, p. 1513, Doc 2011-6228 , or 2011 TNT 59-3 .

²² H.R. Rep. 103-111, at 600 (1993).

²³ Alan D. Viard and Amy Roden, "Big Business: The Other Engine of Economic Growth," AEI Tax Policy Outlook (June 2009), available at http://www.aei.org/outlook/politics-and-public-opinion/judicial/big-business-the-other-engine-of-economic-growth/.

²⁴ Sullivan, "New Research Weakens Case for Small Business Tax Relief," Tax Notes, Jan. 2, 2012, p. 54, Doc 2011-27084 , 2012 TNT 1-3 ; Sullivan, "Start-Ups, Not Small Businesses, Are Key to Job Creation," Tax Notes, Jan. 9, 2012, p. 158, Doc 2012-183 , 2012 TNT 5-3 .

²⁵ Lisa D. Sergi et al., "Small Business Stock Incentives -- Time for a Fresh Approach" (Oct. 2008), available at http://www.nvca.org. I became aware of this paper through the discussion of it in Sullivan, "New Research," supra note 24.

²⁶ Sullivan, "New Research," supra note 24, suggests that section 1202 be altered to provide an incentive for venture capital, a sector that has featured job creation and innovation. See also Sullivan, "When Should Small Businesses Get a Tax Break?" Tax Notes, Jan. 16, 2012, p. 207, Doc 2012-645 , or 2012 TNT 10-1 . Such a change would undoubtedly be an improvement over the current provision. It is unclear, however, that such a change would be better than outright repeal. That venture capital, or any other sector, creates jobs does not mean that it should expand by more than market forces would dictate under a neutral tax system, so as to justify a special tax preference. And although some types of innovation are likely to be undersupplied by the market because they provide spillover benefits that the innovator cannot capture, it is unclear whether an incentive for venture capital is better suited to address this problem than other policies, such as the research tax credit. In any case, the change proposed by Sullivan would require an almost complete revamping of section 1202 and is better thought of as a replacement for, rather than a modification of, that provision.