Capital Gain Exclusion on Small Business Stock

By Patrick Smith, CPA, Seattle, WA, Francois Hechinger, CPA, San Francisco, CA, and John M. Nuckolls, J.D., San Francisco, CA

Editor: Kevin D. Anderson, CPA, J.D.

Gains & Losses

One of the more intriguing provisions of the Small Business Jobs Act of 2010, P.L. 110-240 (the Jobs Act), is the 100% exclusion from gross income of capital gains from the sale of certain qualified small business stock (QSBS). Generally this provision will allow taxpayers to pay no federal tax on up to $10 million in gain from the sale of certain QSBS. As originally enacted, the provision required taxpayers to have acquired the QSBS after September 27, 2010, and before January 1, 2011, but the latter date was promptly extended for one more year, to January 1, 2012, by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2011, P.L. 111-312.

The Sec. 1202 capital gain exclusion for QSBS has been in existence since 1993. Generally, the amount excluded from gross income was 50% of eligible gains, although the excluded portion was increased to 75% for stock issued in 2009 and most of 2010. The includible portion of the gains was generally taxed at a 28% capital gains rate. Furthermore, an amount equal to 7% of the amount excluded from gross income was a preference for alternative minimum tax (AMT) purposes, which had the effect of increasing alternative minimum taxable income (Sec. 57(a)(7)). Because of the increased tax rate on the portion not excluded from gross income and the AMT preference, most taxpayers enjoyed very little or no federal benefit for the Sec. 1202 exclusion. Some taxpayers did enjoy some state tax benefit from the exclusion. For example, California taxpayers typically experienced reduced California taxes as a result.

With this recent change, however, taxpayers in general will be able to exclude up to $10 million in gain from gross income with no preference for AMT purposes. Clearly, the provision was designed to encourage the formation of small businesses prior to year end with the goal of creating new jobs. To be eligible for the exclusion, the taxpayer must hold the QSBS for more than five years. Thus, the earliest one can benefit from the 100% exclusion would be 2015.

Qualification for Sec. 1202 Exclusion

For QSBS to qualify for the 100% exclusion, all the limitations applicable to investments in qualified small businesses must be met, including the following:

  • The QSBS must be acquired after September 27, 2010, and before January 1, 2012.
  • The QSBS must be held for more than five years (subject to certain exceptions for qualifying tax-free rollovers).
  • The exclusion applies only to noncorporate taxpayers, including passthrough entities such as partnerships, S corporations, regulated investment companies, and common trust funds.
  • The small business must be a domestic C corporation, and the stock purchased must be purchased by the investor upon original issuance from the corporation (directly or through an underwriter).
  • The small business corporation generally must use 80% of its assets (by value) in a qualifying active business (which excludes certain types of businesses, such as financial institutions, farms, professional service firms, hotels and restaurants, and similar businesses) for substantially all of the investor’s holding period.

In addition to identifying specific types of businesses that are not treated as active businesses, Sec. 1202 treats assets as used in the active conduct of a qualified trade or business, even if the corporation does not have any gross income from the activity, if the corporation is engaged in:

  • Start-up activities in connection with:
    • Investigation of the creation or acquisition of an active trade or business;
    • Creation of an active trade or business; or
    • An activity engaged in for profit and for the production of income before the day on which the active trade or business begins, in anticipation of such activity becoming an active trade or business.
  • Activities resulting in the payment or incurring of expenditures that may be treated as research and experimental expenditures; or
  • Activities with respect to certain in-house research expenses.

In order to be a qualified business, the corporation must use 80% of its assets measured by value for one or more qualified trades or businesses (as discussed above). It is unclear when one makes the 80% determination, as there is little guidance on this area of the law. The statute merely requires that the 80% requirement must be maintained during substantially all the taxpayer’s holding period for the stock.

The Code does provide clarification for amounts related to working capital. Any assets that are held as part of the reasonably required working capital needs of a qualified trade or business are treated as used in the active conduct of a qualified trade or business. If a corporation has been in existence for at least two years, however, no more than 50% of the corporation’s assets may qualify as used in the active conduct of a qualified trade or business by reason of these rules. Similarly, assets held for investment that are reasonably expected to be used within two years to finance research and experimentation or to increase working capital needs would also be considered to be used in the active conduct of a trade or business and would count toward the 80% requirement.

Rights to computer software that produces active business computer software royalties are considered an asset used in the active conduct of a trade or business.

The small business must not have made certain redemptions of its stock prior to or following the acquisition of the stock.

The aggregate gross assets (defined generally as cash plus the aggregate adjusted tax basis of other property) held by the small business must not exceed $50 million at any time before or immediately following the investment by the investor (including amounts received by the small business from the investor).

In addition, there is a per-issuer limit on gains eligible for the exclusion equal to the greater of $10 million or 10 times the adjusted tax basis of stock issued by the small business and disposed of by the investor during a particular year.

The exclusion under Sec. 1202 is designed for those who bear the entrepreneurial risk of a new company. There are restrictions for those investors who hold QSBS stock and hold offsetting short positions. Having an offsetting short position before the five-year holding period requirement is satisfied would prevent the stock from reaching the necessary holding period, as the taxpayer is deprived of the benefits of Sec. 1202 once the short positions are locked in. In addition, if an offsetting short position is locked in after the five-year holding period requirement is satisfied, the future appreciation in the stock is no longer afforded Sec. 1202 exclusion. In the latter case, in order to obtain any benefits under Sec. 1202, the taxpayer must elect to recognize gain as if the QSBS had been sold on the date of acquisition of the short position for its fair market value.

Finally, an option to acquire QSBS does not constitute QSBS for purposes of Sec. 1202. A taxpayer must exercise the option and hold the stock for a five-year period during which the stock qualifies as Sec. 1202 stock. Holding the option while a corporation is engaged in a qualified small business does not qualify the taxpayer for the benefits of Sec. 1202, inasmuch as Sec. 1202 stock must be originally issued stock, rather than an option to acquire such stock.

Sec. 1202 is not elective. A Sec. 1202 gain must be reported as such on the taxpayer’s return by reporting 100% of the gain and then excluding the appropriate exclusion percentage at the time of the gain (50% for stock acquired before February 18, 2009, or after December 31, 2011; 60% for stock in certain empowerment zone businesses; 75% for qualified small business stock acquired after February 17, 2009, and before September 28, 2010; and 100% if the stock was acquired after September 27, 2010, and before January 1, 2012, and was held for more than five years).

Except for brief regulations dealing with the effect of certain redemptions by corporations, there are no income tax regulations providing guidance under Sec. 1202, and the IRS has issued only a few rulings. There is some question as to whether the $10 million amount in the statute prior to the 2009 change in the law referred to the total amount of gain excludible or the total amount of gain eligible for a 50% exclusion. Under the former approach, a taxpayer could exclude 50% of the first $20 million of gain, for a total exclusion of $10 million. Under the latter approach, a taxpayer could exclude 50% of the first $10 million, for a total exclusion of $5 million. This ambiguity was pointed out by well-known tax scholars who noted that taxpayers can take this position due to a statement in IRS Publication 550, Investment Income and Expenses (2010), and a literal reading of the provisions of Sec. 1202 (see Bittker, McMahon, and Zelenak, Federal Income Taxation of Individuals ¶9.07 (WG&L 2002)). This recent change in the law clearly allows the full $10 million exclusion versus $5 million ($10 million × 50%) or $7,500,000 ($10 million × 75%), but it still provides no clear guidance on the application of the stated maximum dollar amount of the exclusion where the exclusion percentage was less than 100%.

Planning Opportunities

Individuals or passthrough entities wanting to start up a new company or invest in new companies should consider taking advantage of the new 100% exclusion and acquire newly issued QSBS prior to the end of 2011. Employees or directors holding stock options in qualified small businesses should consider exercising the options before the end of the year as well.

Those founders that had originally chosen the limited liability company or partnership form of business for their start-up business may wish to reconsider their method of taxation. A conversion from an entity taxed as a partnership to one taxed as a C corporation may qualify for qualified small business status if the requirements discussed above are satisfied and the method chosen to incorporate satisfies the original issuance requirement set forth above. In contrast, an existing S corporation would not be eligible to be converted to an eligible C corporation that would qualify for the 100% exclusion with respect to any stock that shareholders hold at the time of conversion.

Follow-on investments in either cash or property in exchange for stock as an original issuance from the corporation or through an underwriter also qualify for exclusion of a small business stock gain, provided the corporation meets the requirements of a qualified small business at the time the new stock is issued.

In the above opportunities, these transactions would result in the acquisition of QSBS as long as the aggregate gross assets held by the small business do not exceed $50 million at any time before or immediately following the investment by the investor.


Kevin Anderson is a partner, National Tax Services, with BDO USA, LLP, in Bethesda, MD.

For additional information about these items, contact Mr. Anderson at (301) 634-0222 or

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