Qualified Small Business Stock: An Opportunity for Tech Startups

By Brad McGuire, CPA, and Jim Mal­czewski, CPA, Appleton, Wis.

Editor: Alan Wong, CPA

Gains & Losses

Technology companies, in particular biotech, face large hurdles in raising capital to sustain operations until they have a viable product in a marketplace. As a result, their capitalization schedules are unlike those of other types of businesses where capital is provided once at startup and operations are funded from sales or services that are made or delivered soon after organization. The existence of convertible debt, incentive stock options, warrants, and preferred stock, along with the need for additional capital, creates opportunities to issue additional qualified small business stock (QSBS) in 2013. The benefit of the QSBS gain exclusion is enhanced with the increase in capital gain rates that went into effect in 2013.

QSBS issued after Aug. 10, 1993, and before Feb. 18, 2009, was eligible for a 50% exclusion from capital gains; however, the balance was subject to the 28% capital gain rate. The alternative minimum tax (AMT) also came into play to further reduce the small benefit derived from the exclusion. This limited benefit also reduced the effort that practitioners put into planning around Sec. 1202. That changed with the enactment of the American Recovery and Reinvestment Act of 2009 (ARRA), P.L. 111-5. ARRA increased the exclusion rate from 50% to 75%, but retained the 28% rate on the remainder, as well as the alternative minimum taxable income adjustment. The 75% exclusion is effective for stock acquired from Feb. 18, 2009, through Sept. 27, 2010. This gave practitioners more incentive to begin exploring opportunities, but the exclusion was still limited, still had AMT implications, and required a stock sale to take advantage of the tax benefit.

On Sept. 28, 2010, the Small Business Jobs Act of 2010, P.L. 111-240, increased the exclusion to 100% for both regular and AMT purposes but only for stock issued prior to Dec. 31, 2010. The 100% exclusion was then extended on Dec. 17, 2010, by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312, through Dec. 31, 2011. The 100% exclusion provision expired on Dec. 31, 2011, but it was restored retroactively by the American Taxpayer Relief Act of 2012, P.L. 112-240, which was signed into law on Jan. 2, 2013. The extension is temporary through Dec. 31, 2013.

The history of this provision has not allowed much time for tax practitioners to maximize its use. With the provision set to expire again on Dec. 31, 2013, now is the time to work with clients to attempt to maximize the amount of future gains that could be excluded entirely from federal tax. Unless the 100% exclusion is extended, QSBS gain on stock issued in 2014 and after will revert to a 50% exclusion, and a portion of the excluded gain will be subject to AMT. Due to the various effective dates and exclusion percentages, it is imperative to track original issue dates of the stock, as well as to understand which stock transactions constitute a new issue. Issuers and investors of QSBS must document the original issue dates and qualification as QSBS at the time of original issue.

The exclusion for QSBS gain described in Sec. 1202 is not unlimited and is computed at the shareholder level. In general, the amount of QSBS gain that can be excluded from income is the greater of $10 million or 10 times the aggregate adjusted basis of the QSBS issued by the corporation and disposed of by the taxpayer during the tax year. Eligible shareholders include individuals and passthrough entities only; corporate shareholders are not eligible. The $10 million limit is a lifetime aggregate amount that must be tracked per issuer by the taxpayer. Adjusted basis is determined without regard to any addition to basis after the date on which the stock was originally issued. Eligible gain means any gain from the sale or exchange of QSBS that is held for more than five years.

QSBS Defined

The definition of QSBS seems relatively simple at first glance, but it becomes more complicated upon further reading. To qualify as QSBS, the corporation must meet the definition at the time the stock is originally issued to the taxpayer reporting the gain. QSBS includes any stock in a C corporation received in exchange for either money or property or as compensation for services provided to the corporation.

In general, QSBS includes stock in a domestic C corporation if the aggregate gross assets of that corporation did not exceed $50 million either before or immediately after the issuance of the stock. Aggregate gross assets means the amount of cash and the aggregate adjusted basis of other property held by the corporation. In the case of appreciated contributed property, the adjusted basis of the property will be determined as if the property were contributed at its fair market value. The $50 million limit includes all corporations within a parent-subsidiary controlled group. The ownership threshold for a parent-subsidiary controlled group is 50% ownership of the subsidiary for this purpose.

Care must be taken to review and assure that the stock not only met the QSBS definition at the time of issue but also to document that the stock continued to meet certain requirements that must be maintained over the holding period. There is not much guidance in the way of regulations or case law, due to the relatively few taxpayers who used the provision before 2009 and the fact that no QSBS eligible for 100% gain has yet been sold.

An additional requirement is that the corporation must meet an active business requirement for “substantially all” of the taxpayer’s holding period for the stock. Active business is defined as using at least 80% of the assets by value of the corporation in the active conduct of one or more qualified trades or businesses. Special rules apply for startup activities, research and experimental expenditures under Sec. 174, or activities with respect to in-house research expenses described in Sec. 41. Assets used in these categories are deemed to be used in an active trade or business. The Code also allows for assets held for “reasonably required working capital needs.” Other key areas to consider are limits on real estate holdings, nonsubsidiary stock holdings, and computer software royalties. These requirements must be monitored over the taxpayer’s holding period, not simply at the time of stock issuance.

The definition of qualified trade or business specifically excludes professional services such as health care, law, engineering, architecture, accounting, actuarial sciences, performing arts, consulting, athletics, financial services, brokerage services, or any other trade where the principal asset of the trade is the reputation or skill of one or more of its employees. Also excluded are banking, insurance, financing, leasing, investing, or similar businesses; farming activities; and businesses involving the production or extraction of products eligible to receive a depletion deduction. Additionally, businesses operating a hotel, motel, restaurant, or similar business are statutorily excluded. Care must be taken to determine that the corporation issuing stock purported to be QSBS is not involved in any of the prohibited trades. It bears repeating that this qualification is not only important at the time of issuance but also during the entire holding period.


Another opportunity for holders of QSBS is provided by Sec. 1045. Secs. 1045 and 1202 define QSBS in the same manner, which will be discussed in the coming paragraphs. This option is available to investors in QSBS that have held the stock for at least six months. Sec. 1045 allows a holder of QSBS to roll over gain into replacement QSBS. The taxpayer must invest in the replacement QSBS within 60 days of the sale of the QSBS. The taxpayer will only recognize gain to the extent that the amount realized on the sale exceeds the cost of any QSBS purchased during the replacement period (less any portion of that cost previously taken into account under Sec. 1045). The amount of the deferred gain reduces the basis in the replacement QSBS, so any gain not recognized currently is deferred, not excluded.

There is no specific language in either Sec. 1202 or 1045 that indicates the two sections are mutually exclusive. Therefore, it would be reasonable to conclude that a taxpayer who exceeds the dollar limits of Sec. 1202 could use Sec. 1045 to defer the excess gain. Obviously, the QSBS gain would have to meet the longer five-year holding period for Sec. 1202 exclusion.


Since the 100% exclusion is set to expire on Dec. 31, 2013, startup tech companies and other qualifying C corporations should look at their current and planned capital transactions for opportunities to increase the amount of stock issued that would qualify for the 100% exclusion. This means creating newly issued stock in 2013. By issuing stock in 2013, a corporation may be able to improve the position of its shareholders that originally received shares prior to 2009. Having stock that is eligible for the 100% exclusion may also become a negotiating tool for the exit of the founders.

However, it does not make sense to ignore the tax consequences of transactions, in the interest of issuing new QSBS. For instance, exercising stock options would be a way to get additional QSBS eligible for the 100% exclusion. Consideration must be given to compare paying tax currently at ordinary income tax rates versus the potential for a zero tax stock sale at least five years in the future.

This may make sense, or it may not. However, if a plan is already in place to exercise shares, if they are about to expire soon after Dec. 31, 2013, or if the strike price is near the fair market value price and current taxes are minimal, the exercise of the option in 2013 as opposed to 2014 is worth considering. Convertible debt is another area that may yield results by accelerating conversion during 2013. Practitioners need to be wary of triggering cancellation-of-debt income from changing terms of outstanding debt as well as triggering interest income on the conversion, whether or not the interest is paid in cash or in additional stock.

This is also a transaction where taxable income will be recognized, yet it may be beneficial to do so in 2013 rather than 2014. Shareholders receiving restricted stock will have another reason to consider a Sec. 83(b) election to lock the share issue date in 2013. Noncompensatory avenues to increase shares issued in 2013 could be considered as well. Such options could involve the declaration of dividends with a dividend reinvestment plan or, more simply, the issuance of new shares for cash or property.

In summary, practitioners should proactively work with C corporation clients and their attorneys to consider ways to increase the number of QSBS shares that are eligible for the 100% exclusion. This provision in Sec. 1202, along with the rollover provision of Sec. 1045, could provide a very tax-favorable exit strategy. Now is the time to assure this option is available and maximized. The clock is ticking, again, on this provision, which reverts to a 50% exclusion for stock issued after Dec. 31, 2013, greatly limiting the planning value. Reactive tax planning involves answering clients’ questions in five years when they are considering a sale; proactive tax planning involves planning now to maximize the potential benefit of QSBS in the years ahead when an exit is being considered.


Alan Wong is a senior manager–tax with Baker Tilly Virchow Krause LLP, in New York City.

For additional information about these items, contact Mr. Wong at 212-792-4986, ext. 986, or awong@bakertilly.com.

Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.

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