In the past several years the federal government has created a number of tax incentives to encourage investment in small businesses.During the recent economic downturn, the terms of these tax incentives were particularly generous, to the point where a complete exemption from federal income tax on gains from the sale of certain stock was — and still is — possible. Although some tax incentives have expired, there remains an opportunity for investors to make investments that could qualify for a full federal income tax exemption on a subsequent sale.
Exclusion of 50 - 100 Percent of Capital Gains from the Capital Gains Tax Calculation
For taxpayers other than corporations, Internal Revenue Code Sec. 1202 excludes from gross income at least 50 percent of the gain recognized on the sale or exchange of qualified small business stock (QSBS) that is held more than five years, but for qualifying stock acquired after February 17, 2009 and on or before September 27, 2010, the exclusion percentage is 75 percent, and for qualifying stock acquired after September 27, 2010 and before January 1, 2014, the exclusion percentage is 100 percent! The gain eligible to be excluded is limited to the greater of $10 million or 10 times the taxpayer’s basis in the stock, computed on a per-issuer basis. The amount of any gain not excluded is subject to a maximum tax rate of 28 percent.
A taxpayer does not have to own stock directly to benefit from the QSBS rules. Ownership through a partnership, S corporation, investment company or common trust fund is acceptable provided all other QSBS eligibility requirements are met.
Alternative minimum tax (AMT) does not apply to gain qualifying for the 100 percent exclusion. For sales of stock which qualify for a 50 percent to 75 percent exclusion, 7 percent of the excluded gain must be included as a tax preference for AMT purposes. For example, if a taxpayer qualifies for the 50 percent exclusion, 53.5 percent of the gain must be included in alternative minimum taxable income which generates an AMT rate of 13.91 percent or 14.98 percent, depending on the taxpayer’s AMT bracket.
Deferred Capital Gains Taxes on Qualified Small Business Stock
Under Internal Revenue Code Section 1045, gain on sales of QSBS held more than six months is not currently taxed to the extent the sales proceeds are reinvested in QSBS within 60 days of the sale. The taxpayer must reduce the basis in the QSBS acquired by any deferred gain.
Qualified Small Business Stock Defined
A qualified small business is a subchapter C corporation. A qualified small business generally cannot own real property that is not used in the active conduct of a qualified trade or business with a value exceeding 10 percent of its total assets; or portfolio stock or securities with a value exceeding 10 percent of its total assets in excess of liabilities.
To qualify as QSBS, stock must be:
- Issued by a domestic C corporation with no more than $50 million of gross assets at the time of issuance
- Issued by a corporation that uses at least 80 percent of its assets in an active trade or business
- Issued after Aug. 10, 1993
- Held by a taxpayer other than a corporation
- Acquired by the taxpayer on original issuance (there are exceptions to this rule)
- Held for more than six months to be eligible for a tax-free rollover under Internal Revenue Code Section 1045 and for more than five years to qualify for gain exclusion under Section 1202.
A qualified small business currently formed as a limited liability company taxed as a partnership or an S corporation may want to consider whether conversion to a C corporation before January 1, 2014 is advisable in order to allow shareholders to potentially qualify for Section 1202 upon a future disposition. A quantitative analysis of the risks and rewards of this strategy would need to be carefully evaluated.