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Taxation of Qualified Small Business Stock: Congress Offers a Large Benefit, if You Can Squeeze into a Small Window

Taxation of Qualified Small Business Stock: Congress Offers a Large Benefit, if You Can Squeeze into a Small Window

Note: This post was updated on January 23, 2013 to reflect changes in the law.

While tax planning should not be the determining factor in making an investment, it certainly should be a factor.  That is why, for at least the past 18 months, we have considered the qualifying small business status of a company in which we are looking to invest.  Two tax planning opportunities exist for investors in such companies, and the tax savings from either could be substantial.

1. Elimination or Reduction of Federal Tax on Gain[1]

Gain (“QSB Gains”) from the sale of “qualified small business stock” (“QSB Stock”) (defined below) acquired by certain taxpayers after September 28, 2010 and before January 1, 2014 may qualify for a 100% exclusion from all Federal taxes if the stock is held for five years.[2]  This would mean that there would be no Federal income tax, capital gains or alternative minimum tax (“AMT”)[3] on the gain.  Period.  If QSB Stock was acquired at other times, taxpayers may be eligible to exclude 50% or 75% of the QSB Gain on the sale, depending upon when the QSB Stock was acquired and provided that the taxpayer holds it for five years, but the AMT may reduce some or most of the benefit.

QSB Stock is:

  • stock acquired from a domestic “C” corporation (i.e., not an “S” corporation)
  • that is engaged in an active trade or business (defined below)
  • whose gross assets do not exceed $50 million,
  • provided that the stock is held for at least five years.

The timing of the acquisition of the stock will impact on the taxation of the gain when the stock is finally sold:

50% Exclusion: Taxpayers who receive a QSB Gain from the sale of QSB Stock acquired between August 11, 1993 and February 17, 2009 may be eligible to exclude 50%[4] of the gain if the stock is held for more than five years. The amount of the overall gain eligible for this computation is limited to the greater of (a) 10 times the taxpayer's basis in the stock, or (b) $10 million, reduced by the amount of all previous QSB Gains the taxpayer has excluded.  This gain, however, would be subject to the AMT, which will vitiate most of the Federal tax benefit, although a state tax benefit may be available.

75% Exclusion: The American Recovery and Reinvestment Act of 2009 (the “2009 Stimulus Bill”) increased the exclusion from 50 percent to 75 percent for QSB Stock acquired between February 18, 2009 and September 28, 2010.   This gain, however, would be subject to the AMT which will vitiate a large portion of the Federal tax benefit, although a state tax benefit may be available.

100% Exclusion: The Small Business Jobs Act of 2010 increased the exclusion to 100% of the QSB Gain for stock acquired between September 28, 2010 and December 31, 2011, and the American Taxpayer Relief Act of 2012, which President Obama signed on January 2, 2013, retroactively extended the 100% exclusion from January 1, 2012 to December 31, 2013.  The AMT will not apply to stock acquired during this period.

The amount of gain that can be excluded equals the greater of (a) $10 million (the “$10mm Limitation”), or (b) 10 times the amount invested (the “10x Limitation”).  This limit creates for a tax planning opportunity for founders or early stage investors.  If a founder forms her company as a limited liability company and later converts to a corporation, the 10x Limitation will be based upon the value of the company at the time of conversion, not the amount she contributed to bootstrap it.  If done in connection with a funding round, 10 times the value of the founder’s shares may result in an amount greater than the $10mm Limitation, thus increasing the potential exclusion. 

In summary, after the exclusions, and considering the Alternative Minimum Tax, the tax rates applicable to QSB Gains are as follows:

Regular Capital Gains

QSB Gains Eligible for 50% Exclusion (Stock acquired on or before 2/17/2009)

QSB Gains Eligible for 75% Exclusion (Stock acquired after 2/17/2009 and on or before 9/28/2010)

QSB Gains Eligible for 100% Exclusion (Stock acquired after 9/28/2010 and on or before 1/1/2014)

QSB Gains Eligible for 50% Exclusion (Stock acquired after 12/31/2013)

(current law-subject to change)

Standard Tax Rate

AMT Tax Rate

Standard Tax Rate

AMT Tax Rate

Standard Tax Rate

AMT Tax Rate

Standard Tax Rate

AMT Tax Rate

Standard Tax Rate

AMT Tax Rate

15%

28%

14%

14.98%

7%

8.47%

0%

0%

14%

14.98%

 

Qualified "small business stock" defined: A corporation whose stock qualifies for this exclusion must be domestic “C” corporation. A taxpayer must hold the stock for five years to qualify for the exclusion.  The Corporation must devote 80 percent of its assets to the active conduct of one or more businesses, not including:

  • a business engaged in health, law, engineering or certain other services, consulting, or financial services;
  • any other trade or business whose principal asset is the reputation or skill of one or more of its employees;
  • a business engaged in banking, insurance, financing, leasing, investing or similar businesses;
  • farming or mineral extraction; or
  • the operation of a hotel, motel, restaurant or similar business.

Not more than 10 percent of the corporation’s assets may be non-business realty. Start-up and research may be considered as an active business, and working capital needs are taken into account.  Limitations also exist on redemptions by the QSB of its own stock.

Qualified "small business" defined: To qualify for the exclusion as a small business when the stock is issued, the corporation’s gross assets cannot exceed $50 million. The corporation, including all “over 50-percent-owned” subsidiaries, cannot have an aggregate capitalization (i.e., gross assets) of more than $50 million. This includes cash, the value of contributed property, and the bases of other assets, without regard for short-term debt.  Finally, the corporation must agree to any IRS reporting requirements, although these requirements have not yet been issued.

2. Deferral of Federal Tax on Gain

Under Code Sec. 1045, which was enacted by Congress in 1997, gains on QSB stock sales can be deferred if the proceeds are reinvested in replacement QSB stock purchased within 60 days of the sale.

Generally, QSB stock under Sec. 1045 has the same definition as QSB stock under Sec. 1202, with two changes:

  • only a six-month holding period applies to QSB stock sold and reinvested under Sec. 1045 (not the five year requirement under Sec. 1202); and
  • the QSB must have met the active business requirement for only the first six months following the QSB stock acquisition.

If the proceeds from the sale of QSB stock are reinvested in replacement QSB stock, gain is only recognized to the extent the reinvested amount is less than the amount realized on the sale or exchange of the original QSB stock. The holding period in the replacement stock includes the holding period in the original QSB stock. The deferred gain on the QSB stock sale serves to reduce the basis in the replacement QSB stock. The election to defer gains on QSB stock sales is made on a timely filed return, including extensions, for the year in which the QSB stock is sold (Rev. Proc. 98-48 for election procedures).

Image source: http://www.flickr.com/photos/68751915@N05/6736194099/in/photostream

[1]  Different state and local tax rules may apply to the gains described in this writing.  I urge you to check with your tax adviser concerning your particular situation.

[2] Internal Revenue Code section 1202.  Other citations are generally omitted herein, although most would refer to IRC section 1202

[3] Internal Revenue Code section 57(a)(7)

[4] 60 percent for stock of certain empowerment zone businesses

 

This information is offered by ff Venture Capital as a general description of the subject matter presented, and is not intended to provide an exhaustive analysis of applicable Federal, state or local tax laws.  The reader is encouraged to seek advice from his or her own tax adviser, based upon the specifics of his or her own tax and financial situation.  To ensure compliance with requirements imposed by the IRS, ff Venture Capital informs you that any U.S. Federal tax advice contained in this document is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

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