Key Consideration: The Tax Benefits of the Qualified Small Business Stock Gain Exclusion
Under Section 1202, the qualified small business stock (QSBS) gain exclusion provides significant tax benefits by allowing the exclusion of up to 100 percent of taxable gain from the sale of QSBS.
If the Biden administration’s plan to increase long-term capital gains rates becomes a reality, qualifying for the QSBS gain exclusion is likely to take on greater importance. However, without regard to whether capital gain tax rates increase under the Biden administration, the QSBS exclusion should be a key consideration for investors, founders, and qualifying businesses looking to raise capital.
Qualified small business stock (QSBS)
To qualify as QSBS, the stock must be C corporation stock (S corporation stock does not qualify). The stock must be acquired from the C corporation (not from another stockholder except in limited circumstances) in exchange for money, other Section 1202 stock, other property (excluding non-Section 1202 stock), or services provided to the corporation. The corporation must meet certain active business requirements (based on asset use) during substantially all of the taxpayer’s stock holding period, and the aggregate gross assets of the corporation (and certain subsidiaries) must not have exceeded $50 million at any time before or immediately after the taxpayer’s receipt of the stock.
Stock held in corporations conducting certain industry-specific trades or businesses (e.g., health, law, engineering, architecture, accounting, etc.) and consulting (or other personal services) trades or businesses will not qualify as QSBS.
QSBS gain exclusion
The gain exclusion applies to non-corporate taxpayers with respect to the sale of QSBS held directly by them (or held indirectly through a partnership or S corporation) for more than five years. The amount of gain that may be excluded by a taxpayer (e.g., an individual stockholder) for federal income tax purposes (as well as for net investment income tax and alternative minimum tax purposes) is the greater of $10 million or 10x the aggregate “adjusted stock basis” of QSBS sold during the taxable year. The exclusion amount varies depending on when the stock is acquired.
1) QSBS acquired between 8/11/1993 – 2/17/2009 (50 percent gain exclusion);
2) QSBS acquired between 2/18/2009 – 9/27/2010 (75 percent gain exclusion); and
3) QSBS acquired after 9/27/2010 (100 percent gain exclusion).
For example, if the QSBS sold was acquired during the 50 percent gain exclusion period, the taxpayer would be permitted to exclude 50 percent of the eligible gain up to a maximum excluded amount equal to the greater of $5 million (50 percent of $10 million) or 50 percent of 10x the aggregate “adjusted stock basis” of QSBS sold during the taxable year.
The additional amount of gain that would have been excluded under Section 1202 if the 100 percent gain exclusion (rather than the 50 percent gain exclusion) applied would be taxed at a 28 percent federal income tax rate. Therefore, assuming the applicable cap is 50 percent of $10 million, the effective federal income tax rate for $10 million of eligible gain recognized on the sale of QSBS acquired during the 50 percent gain exclusion period is 14 percent (i.e., no tax on 50 percent of the gain and tax at 28 percent on the remaining 50 percent).
With respect to the exclusion of QSBS gain at the state level, it is important to determine whether the applicable state follows federal tax law with respect to Section 1202. Qualification for the exclusion at the federal level does not necessarily mean the taxpayer will also be able to exclude the gain at the state level.
When to consider or reconsider Section 1202
Founders, early-stage investors, and start-up businesses should consider whether setting up their operations in a C corporation to take advantage of QSBS is appropriate. If the business is not originally set up as a C corporation, businesses may be able to convert to a C corporation structure and issue QSBS at the time of conversion. Investors should consider whether it is possible to receive QSBS in the context of an investment in an existing business. Also, Section 1202 needs consideration with respect to existing shareholders and/or purchasers in the context of M&A transactions.
Stock redemptions may result in the failure of stock issued within two years before or after the redemption to qualify as QSBS. Transfers of stock from a stockholder to a partnership (including an LLC taxed as a partnership) will result in loss of QSBS treatment for the transferred stock. Also, special rules and requirements apply to QSBS issued by the corporation to a partnership (including an LLC taxed as a partnership) or an S Corporation.
Section 1202 will likely take on even greater importance given the possibility of capital gain tax rate increases. It allows founders and investors of corporations to exclude up to 100 percent of their capital gains derived from the sale of qualified small business stock (QSBS) held for more than five years (subject to limitations). Because the gain exclusion percentage for a shareholder depends on the QSBS issuance date, as time goes on, more investors are becoming eligible for the full, 100 percent exclusion – and thus its rise in popularity.
Further, 2021 could have far-reaching changes to the taxation of long-term capital gains, which are taxed at graduated rates under the individual income tax. Today, the highest rate is generally 20 percent (23.8 percent including the net investment income tax, if applicable, based on the taxpayer’s modified adjusted gross income (AGI)).
Under the Biden Administration’s current proposal, long-term capital gains of taxpayers with AGI of more than $1 million would be taxed at ordinary income tax rates to the extent that the taxpayer’s income exceeds $1 million ($500,000 for married filing separately), indexed for inflation after 2022. Currently, the highest rate for individuals is 37 percent (40.8 percent including the net investment income tax), though the proposal also includes a proposal to raise the individual rate to as much as 39.6 percent (43.4 percent including the net investment income tax).
While reinvestments into Qualified Opportunity Zones, like-kind exchanges (possibly limited going forward), and reinvestment of proceeds into qualified replacement property from sales of corporate stock to an Employee Stock Ownership Plan provide some deferral opportunities, Section 1202 is the only provision that provides an exclusion opportunity for QSBS. The higher the capital gains tax rate rises, the greater the potential tax benefit of utilizing an available Section 1202 exclusion.
For questions about these proposed changes or any other related manner, contact your Weiss tax professional at your convenience.
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