Excluding and Rolling Over Gain on Disposition of Qualified Small Business Stock

Editor: Albert B. Ellentuck, Esq.

Sec. 1202 allows noncorporate taxpayers to exclude from gross income 50% of any gain from the sale or exchange of qualified small business stock (QSBS) acquired before Feb. 18, 2009, or after Dec. 31, 2011, and held for more than five years. This provision applies to stock issued after Aug. 10, 1993. The 50% capital gain exclusion removes some of the double taxation that applies to C corporation stock ownership if the fairly restrictive requirements can be met. The major impediments are limits on the size of the business, types of eligible businesses, and types of assets a corporation can have and still meet the definition of a qualified small business. In addition, S corporation shareholders qualify for the gain exclusion only if they held their interest in the S corporation when the QSBS stock was acquired and at all times until the stock was disposed of.

Although the maximum tax rate on an individual’s net long-term capital gain was 15% for 2012, a 28% capital gains rate applies to the sale of the QSBS after the 50% reduction in gain from the sale. Therefore, the effective regular tax rate for a sale of QSBS is 14% (28% × 50%). However, 7% of the excluded gain is an alternative minimum tax (AMT) preference item under Sec. 57(a)(7). If the entire preference is subject to the 28% AMT rate, the effective rate on the gain for taxpayers subject to AMT is 14.98% ([50% + (50% × 7%)] × 28%). Thus, the QSBS exclusion provided little benefit through the end of 2012. However, taxpayers (other than C corporations) who realize a gain from the disposition of QSBS held more than six months can elect under Sec. 1045 to roll over their gain to the extent they acquire replacement QSBS during the 60-day period beginning on the date of the sale. Gain is recognized to the extent the sales proceeds exceed the cost of replacement stock.

Beginning in 2013, the regular long-term capital gain rate returned to 20% (barring any last-minute changes by Congress) so the difference between the two rates is 6% (20% regular long-term capital gain rate versus 14% effective rate under Sec. 1202). Thus, it makes sense to meet the QSBS requirements when possible, since the stock may be sold when capital gains are taxed at a higher rate than 15%. Also, the ability under Sec. 1045 to roll over gains on QSBS to replacement stock remains an advantage.

Example 1: H Inc. issues QSBS to its shareholders. H has a marginal corporate tax rate of 34%. Its taxable income minus the corporate income tax it pays increases the value of its stock dollar for dollar. When shareholders sell the stock, after meeting the five-year holding period, corporate income is effectively taxed again at a 9.24% rate (shareholder’s gain includes 66% of corporate income, the amount remaining after corporate-level tax; gain is 50% excludable and then taxed at a 28% capital gains rate [(100% – 34%) × 50% × 28%]. Thus, the combined corporate and shareholder effective tax rate for H and its shareholders is 43.24% (34% + 9.24%).

If the corporate-level rate is less than 34%, so much the better. A corporate-level rate of 25% results in a combined effective tax rate of 35.5% [(100% – 25%) × 50% × 28% = 10.5% + 25% at the corporate level]. A corporate-level rate of 15% results in a combined effective tax rate of only 26.9% [(100% – 15%) × 50% × 28% = 11.9% + 15% at the corporate level].

Increased Gain Exclusion Percentage

The American Recovery and Reinvestment Act of 2009, P.L. 111-5, increased the 50% capital gain exclusion from the sale or exchange of QSBS held more than five years to 75% for qualified stock acquired after Feb. 17, 2009, and before Sept. 28, 2010 (Sec. 1202(a)(3)). Therefore, the effective regular tax rate applicable to those sales is 7% (28% × 25%). However, as noted above, the excluded gain is an AMT preference item under Sec. 57(a)(7). Thus, if the entire preference is subject to the 28% AMT rate, the effective rate on the gain for taxpayers subject to AMT is 12.88% ([25% + (75% × 28%)] × 28%). The 75% gain exclusion will not be available until 2014 due to the five-year holding requirement.

The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312, increased the 75% capital gain exclusion to 100% for QSBS acquired after Sept. 27, 2010, and before Jan. 1, 2012, and held more than five years (Sec. 1202(a)(4)). Although the 100% gain exclusion will not be available until 2015 due to the five-year holding requirement, it is also not subject to the AMT (Sec. 1202(a)(4)(C)).

To summarize, the applicable Sec. 1202 gain exclusion is:

• 50% if the QSBS is acquired before Feb. 18, 2009;
• 75% if the QSBS is acquired after Feb. 17, 2009, and before Sept. 28, 2010;
• 100% if the QSBS is acquired after Sept. 27, 2010, and before Jan. 1, 2012; and
• 50% if the QSBS is acquired after Dec. 31, 2011.

Meeting the Requirements for QSBS Status

QSBS is stock that meets the following requirements (Sec. 1202(c)):

1. The stock is issued after Aug. 10, 1993, by a corporation that at the date of issuance is a qualified small business (a domestic C corporation with cash and other assets totaling $50 million or less, based on adjusted basis, at all times from Aug. 10, 1993, to immediately after the stock is issued). In addition, the corporation must agree to submit reports the IRS requires to verify compliance with this test (Sec. 1202(d)(1)(C)).
2. The noncorporate shareholder acquires the stock in an original issue in exchange for money or other property or as compensation (although some tax-free transfers and exchanges can also qualify—see Secs. 1202(f) and (h)).
3. The stock is issued by an eligible C corporation that meets (on the stock issuance date and during substantially all the period the stock is held) an active business requirement that at least 80% of the value of the corporation’s assets are used in a qualified trade or business (Sec. 1202(e)).

An eligible corporation is any domestic C corporation other than:

1. A domestic international sales corporation (DISC) or former DISC;
2. A corporation (or a direct or indirect subsidiary) that has a Sec. 936 (i.e., possessions credit) election in effect;
3. A regulated investment company (RIC), real estate investment trust (REIT), or real estate mortgage investment conduit (REMIC); or
4. A cooperative (Sec. 1202(e)(4)).

A qualified trade or business is any trade or business other than businesses that (1) provide personal or professional services; (2) own, deal in, or rent real property; (3) operate a farm; (4) operate a hotel, motel, restaurant, or similar business; (5) conduct banking, insurance, leasing, financing, investing, or a similar business; or (6) extract products subject to percentage depletion (Secs. 1202(e)(3) and (7)).

Example 2: R and B opened a car wash business in December 2004. Each contributed $50,000 in capital to the business, which was incorporated as F Inc. and began operations on Jan. 10, 2005. By July 2012, F was operating at four locations. R and B have been approached by K Inc. to sell their F stock for $500,000.

Under normal circumstances, the sale of the F stock would result in long-term capital gains to R and B. Assuming that each had a $50,000 basis in his stock, the gain would be $200,000 ($250,000 – $50,000 basis) for each shareholder. The gain is eligible for a 50% exclusion because:

1. The stock was acquired by the shareholders upon its original issue after Aug. 10, 1993, in exchange for money or other property in a tax-free transfer (Sec. 1202(c)). (The 50% exclusion applies because the stock was acquired before Feb. 18, 2009.)
2. The shareholders have held the stock for at least five years (Sec. 1202(a)(1)).
3. F Inc. is a domestic C corporation that is not a prohibited corporation, such as a REIT, a REMIC, or a RIC (Sec. 1202(e)(4)).
4. The corporation has not held cash and other property with a value in excess of $50 million (Sec. 1202(d)(1)).
5. At least 80% of F’s assets have been used in a qualified trade or business (Sec. 1202(e)(1)(A)).
6. F has not owned real estate that was not used in the active conduct of its business or that exceeded 10% of the value of its gross assets (Sec. 1202(e)(7)), nor has it owned portfolio stock or securities in excess of 10% of its net asset value (Sec. 1202(e)(5)(B)).

Stock issued by an S corporation does not qualify as QSBS (Sec. 1202(c)(1)). However, an S corporation, partnership, or other passthrough entity can own QSBS. (In that case, gain from the disposition of the QSBS would pass through to the entity’s owners.) If a noncorporate owner of the passthrough entity held an interest in the entity during the entire period in which the entity owned the QSBS, the owner of the entity (e.g., an S corporation shareholder) can claim the exclusion on his or her individual income tax return (Sec. 1202(g)).

This case study has been adapted from PPC’s Tax Planning Guide—Closely Held Corporations, 25th Edition, by Albert L. Grasso, R. Barry Johnson, Lewis A. Siegel, Richard Burris, Mary C. Danylak, Kimberly Drechsel, James A. Keller, and Robert Popovich, published by Thomson Tax & Accounting, Fort Worth, Texas, 2012 (800-323-8724; ppc.thomson.com)