One under-publicized tax planning opportunity contained in the Small Business Jobs Act of 2010 (the “2010 Act”), signed into law on September 27, is a provision permitting non-corporate taxpayers to lock in during 2010 a zero percent federal income tax rate on gain (subject to certain limitations) realized on a later sale of certain “qualified small business stock” (“QSBS”). Individuals looking to invest in QSBS, and qualified small business corporations looking to raise capital, may want to take advantage of this planning opportunity. Taxpayers looking to benefit from this provision, however, need to act by year end.
The Internal Revenue Code generally permits an exclusion from income for 50% of a non-corporate taxpayer’s gain realized on the qualifying sale or exchange of QSBS. The determination of whether a particular investment qualifies for this exclusion is initially made at the time of such investment. The exclusion, to the extent available, then applies to gain realized upon a later sale of the underlying stock, which could occur several years later (in fact, the law requires that the stock be held for more than five years in order for the exclusion to apply).
Under pre-2010 Act law, however, any gain remaining after allowance for this exclusion is taxed at a maximum capital gains rate of 28% (in lieu of the general 15% currently applicable rate). In addition, a portion of the excluded gain is required to be treated as a preference item for purposes of the alternative minimum tax (“AMT”), potentially subjecting the taxpayer to this alternative tax regime. The combination of these two collateral effects generally, and sometimes significantly, reduces the potential benefit of the exclusion, inconsistent with the statutory intent of encouraging investment in QSBS. Legislation enacted in 2009 increased the amount of the gain exclusion to 75% for certain purchases of QSBS, but left in place the 28% maximum tax rate on the remaining gain and the AMT preference treatment, thus continuing to dampen the enthusiasm for qualifying investments, even at this increased rate of exclusion.
THE THREE-MONTH OPPORTUNITY
The 2010 Act (i) increases the exclusion rate to 100% for qualifying investments in QSBS made after September 27, 2010 and before the end of the year and (ii) eliminates the AMT preference treatment for the excluded gain on such investments. Accordingly, both of the factors that previously reduced the benefits of investment in QSBS have been eliminated by the 2010 Act for investments covered by its provisions. There is no remaining gain to be taxed at the elevated 28% capital gains tax rate, and taking advantage of the exclusion will not increase a taxpayer’s exposure to the AMT.
Dispositions of QSBS qualifying under the 2010 Act’s provisions, and meeting the other requirements for gain exclusion, including the minimum five-year holding period discussed above and an overall cap on gain that can be excluded discussed below, may thus truly be subject to a zero percent effective federal income tax rate. The 2010 Act’s provisions, however, do not apply to QSBS acquired on or prior to September 27, 2010, or to QSBS acquired after the end of the year, when the regular 50% exclusion and the AMT preference treatment will return. Thus, only acquisitions of QSBS within this three-month window in 2010 create interests eligible for the 100% exclusion and the special AMT treatment on a later sale.
QUALIFIED SMALL BUSINESS STOCK REQUIREMENTS
In order for stock to qualify as QSBS and be entitled to the benefits of the exclusion, the stock must meet the following requirements:
- It must be acquired at original issue in exchange for money or other property (generally excluding stock) or as compensation for services (other than underwriting services), and held for more than five years prior to sale. For stock acquired through the exercise of certain qualifying options, warrants, or convertible bonds, the holding period would begin with the date of exercise (thus, exercise would have to occur by year end in order for 2010 Act’s provisions to apply).
- The issuing corporation must be a qualified small business corporation and must agree to certain reporting requirements.
- The amount of gain that can be excluded by a taxpayer with respect to any single issuing corporation is generally limited to the greater of ten times the adjusted basis of the QSBS disposed of or $10 million.
For this purpose, a qualified small business corporation is a domestic C corporation with aggregate gross assets not exceeding $50 million at any time before or immediately after the issuance of the subject stock. A qualified small business corporation must also satisfy an active business requirement, which generally means that at least 80% of its assets must be used in the active conduct of one or more qualified trades or businesses during substantially all of the holding period for the stock. Under certain circumstances, start-up and research and development activities may be treated as active trade or business activities for this purpose.
Care must be exercised, because some trades or businesses are excluded from being qualified trades or businesses for this purpose, including (i) many professional service businesses, (ii) financial service businesses, (iii) farming businesses, (iv) mining and extraction businesses, and (v) hospitality businesses (hotels, restaurants, or similar businesses). In addition, certain corporations subject to special tax treatment (for example, RICs, REITs, and cooperative corporations) cannot be qualified small business corporations, and certain purchases or redemptions of stock by a qualified small business corporation in close proximity to a stock issuance can cause the loss of QSBS status for the issued stock. Special rules also apply for QSBS held by partnerships, including investment funds treated as partnerships for tax purposes.
The 2010 Act eliminates the erosion of potential tax benefits formerly associated with investments in QSBS. In addition, with capital gains tax rates scheduled to rise over the coming years, the possibility of receiving tax-free capital gains becomes more appealing. Individuals looking to invest in QSBS, and qualified small business corporations looking to raise capital, should consider the limited opportunity to do so before year end to take advantage of the 2010 Act’s provisions. While some members of Congress have proposed extending the 2010 Act’s provisions beyond the end of this year, the prospects for such proposals are uncertain at best.