[Congressional Record Volume 147, Number 27 (Monday, March 5, 2001)]
[Senate]
[Pages S1824-S1826]
From the Congressional Record Online through the Government Publishing Office [www.gpo.gov]

      By Ms. COLLINS (for herself, Mr. Cleland, Mr. Breaux, Mr. Allard, 
        Mr. Chafee, Mr. Lieberman, Ms. Landrieu, Mr. Hatch, and Mr. 
        Hutchinson):
  S. 455. A bill to amend the Internal Revenue Code of 1986 to increase 
and modify the exclusion relating to qualified small business stock and 
for other purposes; to the Committee on Finance.

  Ms. COLLINS. Mr. President, the concerns and needs of small 
businesses have always been a priority for me. When I talk to small 
business owners throughout the State of Maine, I hear over and over 
again that they have two major problems: One is the high cost of health 
insurance. I will be introducing legislation shortly to try to help 
small businesses cope with that issue. The second issue is the need for 
more capital to finance their enterprises.
  Today, I rise to introduce the Encouraging Investment in Small 
Business Act, a bill intended to stimulate private investment in the 
entrepreneurs who drive our economy. I am pleased to be joined today by 
my good friends and staunch supporters of small business, Senators 
Cleland, Breaux, Landrieu, Allard, Chafee, Lieberman, Hutchinson, and 
Hatch.
  The bill we introduce today will encourage long-term investment in 
small and emerging businesses by providing incentives to individuals 
who risk investment in such firms. According to the Small Business 
Administration, small firms account for three-quarters of our Nation's 
employment growth and almost all of our net new jobs. At the same time, 
small businesses face unique financing challenges. Simply put, 
entrepreneurs need access to more capital to start and to expand their 
businesses. As the SBA noted last year, ``Adequate financing for 
rapidly growing firms will be America's greatest economic policy 
challenge of the new century.''
  Just a few months ago, it would have been difficult for us to imagine 
that a capital gap could exist in an economy that had experienced such 
an unprecedented run of prosperity. Venture capital investments in 
emerging firms reached a record $103 billion last year, up 74 percent 
from the year before. Yet, there are signs that the rush of funds is 
subsiding. Venture capital investment activity decreased by 31 percent 
in the fourth quarter of last year, and much of the funds that have 
been raised remains uninvested.
  More important, venture capital funds tend to gravitate towards 
certain types of businesses and geographic regions, and tend to be 
invested in increasingly larger amounts, leaving many small business 
entrepreneurs frozen out of the capital markets. Internet-related 
companies attracted 76 percent of the venture capital invested in the 
first three quarters of 2000. And more than two-thirds of all the 
venture capital invested in the United States in 1999 went to just five 
States. Moreover, the average amount of venture capital invested in 
small businesses increased from $6.6 million in 1998 to $13.3 million 
in 1999, prompting the SBA to conclude that the needs of many small 
businesses for equity financing remain unmet.
  The data paint a troubling picture. It is, unfortunately, a familiar 
one. Take the example of Vladimir Koulchin, a Russian by birth but a 
Mainer in heart and spirit. Vladimir holds a doctorate in biochemistry 
and has 25 years of research experience in the field. Six years ago, 
Mr. Koulchin moved to Portland, ME, to work for a biotechnology firm 
where he became vice president for research and development. This past 
fall, with no funding other than his own, he founded Chemogen with the 
goal of developing products to diagnose, treat, and prevent 
tuberculosis and other dangerous infectious diseases in humans and 
animals. Mr. Koulchin told me how difficult it has been to find the 
seed and early stage capital he needs to get his promising business off 
the ground. He spoke of the relative lack of seed capital in small 
markets and the welcome assistance that strong Federal tax incentives 
could provide.
  Vladimir's experiences are all-too-common. A recent report by the 
National Commission on Entrepreneurship presented findings of 18 focus 
groups with more than 250 entrepreneurs across the country. According 
to the report, the focus groups were ``nearly unanimous in identifying 
difficulties in obtaining seed capital investments.''
  And although the capital gap is pervasive, it disproportionately 
harms women- and minority-owned businesses. The Milken Institute, an 
independent economic think tank, concluded in a research report issued 
last year that, ``While minority businesses are growing faster than 
majority firms in number and revenue, they remain severely constrained 
by a lack of access to capital.'' Moreover, women receive only 12 
percent of all credit provided to small businesses in the U.S. despite 
owning nearly 40 percent of the businesses.
  If we want to remain the world's most entrepreneurial country, where 
small businesses generate the ideas and create the jobs that fuel our 
economy, we must continue to create an environment that nurtures and 
supports entrepreneurs.
  The legislation we are introducing helps to create a supportive 
environment, not by establishing an expensive,

[[Page S1825]]

new Federal program, or adding a complicated new section to our Tax 
Code, but rather by simplifying and improving a provision that is 
already there. The provision, known as section 1202, was added to the 
Internal Revenue Code in 1993 with strong bipartisan support.
  Section 1202 allows investors to exclude from taxable income 50 
percent of the gain from the sale of qualified small business stock 
when the stock is held for at least 5 years. Now, that concept is a 
sound one, but unfortunately, section 1202 prescribes a complicated set 
of requirements, and its attractiveness has been diminished due to the 
fact that when capital gains rates were lowered in 1997, the section 
1202 rate remained the same. In addition, the increasing application of 
the alternative minimum tax has reduced its value. Indeed, early data 
on the use of section 1202 suggests that the alternative minimum tax 
has sharply limited its effectiveness.
  Our bill restores section 1202 to its original role as a potent 
engine of small business capital formation. Our legislation simplifies 
section 1202, enhances its incentives, and eliminates the threat that 
gains on small business stock will be subject to the alternative 
minimum tax. In short, our bill makes a number of commonsense changes 
designed to encourage investment in small business.
  The Encouraging Investment in Small Business Act is supported by the 
National Federation of Independent Business, the National Women's 
Business Council, the National Commission On Entrepreneurship, the 
Biotechnology Industry Organization, and the Biotechnology Association 
Of Maine.
  Our legislation would implement changes recommended by a recent 
Securities and Exchange Commission forum on small business capital 
formation. In sum, our legislation would accommodate the capital-
raising needs of small business, the foundation of our economy.
  Mr. President, I ask unanimous consent that a section-by-section 
summary of the Encouraging Investment in Small Business Act be printed 
in the Record.
  There being no objection, the material was ordered to be printed in 
the Record, as follows:

              Encouraging Investment in Small Business Act

                       Section-by-Section Summary


                            I. Introduction

       The Encouraging Investment in Small Business Act is 
     intended to stimulate private investment in the entrepreneurs 
     who drive our economy. The Act will encourage long-term 
     investment in small and emerging businesses by providing 
     incentives to investors who risk investment in such firms. 
     According to the Small Business Administration, small firms 
     account for three-quarters of our nation's employment growth 
     and almost all of our net new jobs. Small businesses employ 
     52 percent of all private workers, provide 51 percent of our 
     private sector output, and are responsible for a 
     disproportionate share of innovations. Moreover, small 
     businesses are avenues of opportunity for women and 
     minorities, young and elderly workers, and those formerly on 
     public assistance. Yet entrepreneurs need access to more 
     capital to start and expand their businesses.
       In 1993, Section 1202 was added to the Internal Revenue 
     Code in order to encourage investment in small businesses. In 
     brief, Section 1202 permits non-corporate taxpayers to 
     exclude from gross income 50% of the gain from the sale or 
     exchange of qualified small business (``QSB'') stock held for 
     more than five years. The concept is a sound one. However, in 
     practice, Section 1202 has proven to be cumbersome to use and 
     less advantageous than originally intended. As an article in 
     the December 1998 edition of the Tax Adviser noted, ``Sec. 
     1202 places numerous and complex requirements on both the QSB 
     and the shareholder,'' and that the provision ``is no longer 
     the deal it seemed to be.''
       The Encouraging Investment in Small Business Act would 
     amend Section 1202 to eliminate unnecessary complexity and to 
     make it a more robust engine of capital formation for small 
     businesses. As it now stands, the engine needs work. Given 
     (1) reductions in capital gains rates subsequent to Section 
     1202's enactment and (2) the fact that more taxpayers are now 
     subject to the Alternative Minimum tax, Section 1202 is no 
     longer a viable option in many circumstances it was 
     originally intended to address. Moreover, Section 1202's 
     impact will continue to be diluted by a scheduled decrease in 
     long-term capital gains rates applicable to stock purchased 
     after 2000 and the probability that still more taxpayers will 
     be subject to the AMT. To understand the changes the Act 
     would make, it is first necessary to understand how 1202 
     currently works.
       As noted, Section 1202 imposes numerous restrictions on a 
     business that seeks to qualify under its provisions. To be a 
     QSB, a business must be a domestic C corporation with 
     aggregate gross assets of no greater than $50 million at any 
     time prior to or immediately after issuing stock. Certain 
     types of businesses are excluded from QSB status, including 
     banking, insurance, investing, consulting, law, accounting, 
     financial services, and farming concerns as well as hotels 
     and restaurants. Any trade or business that relies on the 
     reputation or skill of one or more of its employees as its 
     principal asset also cannot be a QSB.
       QSB's must also satisfy an ``active business'' requirement. 
     This means that, during substantially all of the time the 
     taxpayer holds the stock, at least 80 percent of the QSB's 
     gross assets must be used by the corporation in the active 
     conduct of the qualified trade or business. Assets used in 
     certain start-up activities or for research, or which are 
     held as ``reasonably required'' working capital are deemed to 
     be used in the active conduct of a qualified trade or 
     business. Two years after a QSB has come into existence, no 
     more than 50 percent of its assets can qualify as ``active'' 
     by virtue of the Section 1202(e)(6) working capital rule.
       As noted, under Section 1202, an individual can exclude 
     from gross income 50% of any gain from the sale or exchange 
     of qualified small business stock originally issued after 
     August 10, 1993 and held for more than five years. Under 
     Section 1045 of the Code, the taxpayer may roll the gain over 
     tax-free provided that the taxpayer (1) has held the QSB 
     stock for more than six months and (2) invests the gain in 
     other QSB stock within 60 days of the sale. Generally, the 
     holding period of the stock purchased will include the 
     holding period of the stock sold.
       The maximum amount of a taxpayer's gain eligible for the 
     Section 1202 exclusion is limited to the greater of $10 
     million and 10 times the aggregate adjusted bases of the 
     stock sold. Gains of Section 1202 stock are taxed at the rate 
     of 28%.


                    II. Section-by-Section Analysis

       Section 1. Short title.
       The ``Encouraging Investment in Small Business Act.''
       Section 2. Increased Exclusion and Other Modifications 
     Applicable to Qualified Small Business Stock.
       (a) Increased Exclusion.
       This provision increases the amount of QSB stock gain that 
     an individual can exclude from gross income from 50 percent 
     to 75 percent.
       (b) Reduction in Holding Period.
       This provision reduces from 5 years to 3 years the period 
     of time in which an individual must hold QSB stock in order 
     to qualify for the 75-percent exclusion. Section 1045's 
     rollover provisions will still apply.
       (c) Repeal of Minimum Tax Preference.
       This provision strikes Section 57(a)(7), which makes 42 
     percent of the amount excluded pursuant to Section 1202 a 
     preference item under the alternative minimum tax. This 
     change is necessary because the AMT provisions in existing 
     law effectively eviscerate the benefit of Section 1202 in 
     certain situations.
       Example. Jane buys Section 1202 stock for $2,000. After 
     five years, she sells the stock for $12,000. Under current 
     law, she excludes half of her gain and is taxed at 28% on the 
     other half [.28 $5,000 = $1,400]. Hence, her tax on the gain 
     is $1,400. However, if Jane is subject to the AMT, she must 
     pay additional taxes of $588, or 28% of 42% of the excluded 
     half of the gain. Jane's total tax bill of $1,988 amounts to 
     an effective rate of 19.9%, or nearly the same as the current 
     maximum tax rate on long-term capital gains of 20%. Under the 
     Encouraging Investment in Small Business Act, Jane would be 
     able to exclude 75% of her gain, would be subject to the 20% 
     rate that applies to most capital gains, and would not have 
     to recognize any of the gain as a preference item for AMT 
     purposes. Hence, her tax bill would be 20% of $2,500, or 
     $500. Absent the change, Jame would have little incentive to 
     invest in a qualified small business over any other business, 
     particularly if she is subject to the AMT. Under the 
     Encouraging Investment in Small Business Act, Section 1202's 
     original potent incentives to investors in small businesses 
     are restored.
       (d)(1) Working Capital Limitations.
       This provision eases Section 1202(e)'s working capital 
     restrictions on qualified small businesses. The provision 
     increases from 2 years to 5 years the time in which assets 
     that are held for investment by a business can be expected to 
     be used to finance research or an increase in working capital 
     needs. In other words, a corporation will be able to hold 
     assets longer, before eventually using them for research or 
     to satisfy increased working capital needs, and still meet 
     the active business requirements of section 1202.
       (d)(2) Exception from Redemption Rules Where Business 
     Purpose.
       Currently, the Section 1202 exclusion does not apply to 
     stock issued by a corporation if the corporation purchases 
     more than 5 percent of its own stock during the 2-year period 
     beginning on the date one year before the issuance of its 
     stock. Under the Encouraging Investment in Small Business 
     Act, this provision would be waived if the issuing 
     corporation could establish that the purchase was made for a 
     business purpose, and not to avoid the provision described 
     above.
       (e) Excluded Qualified Trade or Business.
       This provision tightens the language of Section 1202(e)(3), 
     which excludes certain

[[Page S1826]]

     businesses from QSB status. It does so in two ways. First, it 
     provides that a coproration can be a QSB even if its 
     principal asset, for a temporary period, is the reputation or 
     skill of one or more of its employees. Hence, in the case of 
     a small start-up computer software company, for example, if 
     its employees engage in consulting work, say, in order to 
     generate some cash flow while the software is under 
     development, the company will not be disqualified from QSB 
     status.
       Second, the provision makes it clear that biotechnology and 
     aquaculture companies are not disqualified from QSB status.
       (f) Increase in Cap on Eligible Gain for Joint Returns.
       The Encouraging Investment in Small Business Act fixes a 
     marriage tax penalty provision in Section 1202 by doubling 
     (to $20,000,000) the maximum amount of eligible gain for 
     taxpayers filing joint returns.
       (g) Decrease in Capital Gains Rate
       Section 1202 gains are currently taxed at a rate of 28 
     percent, which, prior to May 7, 1997, had been the maximum 
     marginal rate for net capital gains. The Taxpayer Relief Act 
     of 1997 reduced the maximum capital gain rate for individuals 
     from 28 percent to 20 percent, but left section 1202 gain 
     subject to the 28 percent rate. The Encouraging Investment in 
     Small Business Act would make section 1202 gains subject to 
     the generally-applicable 20 percent rate.
       (h) Increase in Rollover Period for QSB Stock
       Currently, a taxpayer can roll over, tax free, gain from 
     the sale or exchange of QSB stock where the taxpayer uses the 
     proceeds to purchase other QSB stock within 60 days of the 
     sale of the original stock. The Encouraging Investment in 
     Small Business Act would increase the roll over period to 180 
     days, thus increasing the liquidity of QSB stock. A 180-day 
     roll over period is also employed in section 1031 of the 
     Internal Revenue Code for like-kind exchanges.
                                 ______