The Small Business Jobs Act of 2010 (the "Jobs Act"), which was enacted September 27, 2010, contains a brief window of opportunity for non-corporate taxpayers to purchase Qualified Small Business ("QSB") stock (also known as "section 1202 stock") that, if the taxpayer holds the stock for more than five years, is eligible for a 100 percent exclusion of capital gains from sale. This tax break only applies to QSB stock purchased after September 27, 2010 and before January 1, 2011.
Law Prior to the Jobs Act - A Primer on Section 1202
- Eligible taxpayers
- Non-corporate taxpayers who have held their QSB stock for more than five years
- Amount of gain excluded under section 1202
- Under existing law, 50 percent of the gain from the sale of QSB stock is excluded
- The other 50 percent of the gain is not eligible for the 15 percent capital gains rate; instead, it is taxed at 28 percent. As a result, the effective tax rate for 100 percent of the gain from the sale of QSB stock is 14 percent, which is only one percentage point lower than the regular 15 percent capital gains rate.
- Under existing law, 75 percent of the gain from the sale of QSB stock is excluded if the QSB stock was purchased after February 17, 2009 and before January 1, 2011
- The remaining 25 percent is taxed at 28 percent; thus, the effective tax rate for 100 percent of the gain is 7 percent
- There is a per-taxpayer and a per-issuer dollar limit to the amount of gain that can be excluded
- If the amount of gain that is excluded is 50 percent, then the maximum amount of gain that can be excluded with respect to the stock of a single issuer is the greater of (i) $5 million or (ii) five times the taxpayer's basis in the QSB stock of the issuing corporation.
- If the amount of gain that is excluded is 75 percent, then the maximum amount of gain that can be excluded with respect to the stock of a single issuer is the greater of (i) $7.5 million or (ii) 7.5 times the taxpayer's basis in the QSB stock of the issuing corporation.
- AMT treatment
- Under existing law, a fraction of the gain excluded from gross income under section 1202 is treated as a tax preference item and is added back to taxable income for purposes of computing the AMT. For taxable years beginning after 12/31/10, the fraction is 28 percent for stock acquired after December 31, 2000.
New Law - A Brief Window of Opportunity
- For QSB stock acquired by a non-corporate taxpayer after September 27, 2010 and before January 1, 2011, the exclusion is increased to 100 percent of eligible gain
- The dollar limit for the maximum amount of gain that can be excluded is the greater of (i) $10 million or (ii) 10 times the taxpayer's basis in the QSB stock
- QSB stock must be held by the taxpayer for more than five years
- None of the gain is a tax preference for AMT purposes
- The combination of both regular tax and AMT relief means substantial tax savings compared with existing law
What is QSB Stock?
- Issuer must be a domestic C corporation
- Stock must be acquired by the taxpayer at its original issuance
- Gross assets test
- The aggregate gross assets of the issuer must not have exceeded $50 million at any time before the issuance of the QSB stock
- Immediately after the issuance of the QSB stock, the aggregate gross assets of the issuer, including amounts received in the issuance, must not exceed
- $50 million
- Noncash assets are valued at tax basis, not fair market value. Exception for property contributed by a stockholder - treated as having a tax basis equal to fair market value immediately after the contribution.
- Aggregation rule for calculating gross assets; applies to corporations that are members of the same controlled group
- Active business requirement
- Corporation must use at least 80 percent of its assets (measured by value) in the active conduct of one or more "qualified trades or businesses"
- Certain types of businesses are excluded, e.g., certain service businesses, financial service businesses, farming, hotels, restaurants and the extraction of natural resources
- Special rules for start-up activities, R&D, and working capital
- Corporation must satisfy this requirement during "substantially all" of the taxpayer's holding period for the QSB stock
- For existing eligible corporations, close equity financings before year end
- For new start-ups, form the corporation and issue founders stock before year end
- Holders of convertible debt may want to convert to equity before year end
- Warrant holders may want to exercise outstanding warrants before year end
- QSB stock includes stock acquired in exchange for services; therefore:
- Option holders may want to exercise outstanding incentive stock options (ISOs) and nonqualified stock options (NSOs) before year end
- Corporations may want to issue stock options or restricted stock to key management employees before year end
- Limited liability companies and partnerships that are considering converting to a C corporation may want to do so before year end
This is intended to be a brief summary of the basic rules under section 1202 as amended by the Jobs Act. There are numerous exceptions and special rules that may apply under certain circumstances.
If you have questions or would like additional information on the material covered in this Alert, please contact one of the authors, or the Reed Smith attorney with whom you regularly work.
TO ENSURE COMPLIANCE WITH INTERNAL REVENUE SERVICE CIRCULAR 230, WE INFORM YOU THAT ANY U.S. FEDERAL TAX ADVICE CONTAINED IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED, FOR THE PURPOSE OF (1) AVOIDING PENALTIES UNDER THE INTERNAL REVENUE CODE OR (2) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY TAX-RELATED MATTER[S] ADDRESSED HEREIN.