Beginning in 2015, for the first time since its enactment in 1993, Sec. 1202 allows noncorporate taxpayers to exclude from federal income tax 100% of the gain on the sale of certain qualified small business stock (QSBS), limited to the greater of $10 million or 10 times the adjusted basis of the investment. Unlike in prior years, this creates possible opportunities for noncorporate taxpayers who dispose of QSBS in a taxable transaction to potentially exclude the entire gain for federal tax purposes.
To qualify for the exclusion, five criteria generally must be met:
1. The stock must have been directly acquired via an original issuance from a U.S. C corporation (Sec. 1202(c)(1));
2. Both before and immediately after stock issuance, the C corporation's tax basis in gross assets did not exceed $50 million (Sec. 1202(d)(1));
3. The C corporation and shareholders must consent to supply documentation regarding QSBS (Sec. 1202(d)(1)(C));
4. The C corporation conducts certain qualified active trades or businesses (Sec. 1202(e)); and
5. The stock must have been held for more than five years (Sec. 1202(b)(2)).
Sec. 1202 was enacted with a 50% gain exclusion as part of the Omnibus Budget Reconciliation Act of 1993, P.L. 103-66, based on a proposal from Sen. Dale Bumpers, D-Ark. Bumpers intended QSBS to apply to "all types of stock, including common, preferred and convertible preferred stock," and that a "[c]ompany may issue more than one round of qualified stock as long as the total aggregate capitalization does not exceed specified limits" (see generally 139 Cong. Rec. S1609 (Feb. 16, 1993)). This gives taxpayers significant flexibility in planning for potential QSBS treatment.
One may infer that Congress's intent in passing this legislation was to stimulate investment in small businesses and incentivize U.S. noncorporate taxpayers to invest in domestic corporate vehicles.
Why Hasn't the QSBS Exclusion Been Used More in the Past?
The Small Business Jobs Act of 2010, P.L. 111-240, amended Sec. 1202 so that QSBS purchased after Sept. 27, 2010, and before Jan. 1, 2011, could potentially qualify for a 100% gain exclusion from federal regular income tax, alternative minimum tax (AMT), and the 3.8% net investment income tax under Sec. 1411. Subsequent "tax extender" legislation—including the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312; the American Taxpayer Relief Act of 2012, P.L. 112-240; and the Tax Increase Prevention Act of 2014, P.L. 113-295—extended the purchase deadline for the 100% federal gain exclusion in one- to two-year increments for stock acquired after Sept. 27, 2010. And, most recently, Section 126 of the Consolidated Appropriations Act, 2016, P.L. 114-113, made the 100% exclusion permanent, so now QSBS purchased after Dec. 31, 2014, will qualify for full gain exclusion if all other requirements are met.
However, for QSBS purchased on or before Sept. 27, 2010, the Sec. 1202 favorable gain exclusion provision existed for regular income tax purposes, but at a lower exclusion percentage (resulting in the unexcluded portion being subject to a 28% tax rate). Additionally, a portion of the gain excluded for federal income tax purposes was an unfavorable adjustment when computing the AMT. As a result, taxpayers subject to the AMT generally did not realize much, if any, tax benefit using the QSBS exclusion, as the net income tax at a 28% tax rate on the portion of the QSBS gain included for federal tax purposes, versus the AMT rate on a portion of excluded gain being added back, was substantially similar on a net basis.
Stock purchased before or after certain dates, as shown in the exhibit below, may be subject to 50% or even 75% gain exclusion for federal income tax purposes; however, there are separate computations for AMT, yielding an effective federal tax rate of approximately 17% and 9%, respectively, on the gain from QSBS. The exhibit compares the anticipated effective federal tax rates for stock that qualifies as QSBS depending upon when the QSBS was purchased.
Example: Series A corporate shares purchased on Sept. 28, 2010, for $20 million could potentially lead to no federal income tax on a $200 million exit occurring on or after Sept. 29, 2015. Under Sec. 1202(b)(1), QSBS gain exclusion is generally determined on a lot-by-lot basis, versus aggregate holding of an investment in a C corporation. Assuming the same facts as above, if Series B shares were purchased on Sept. 30, 2010, and sold along with Series A shares on Sept. 29, 2015, gain on Series B shares would not qualify for QSBS exclusion, as those shares were not held for more than five years. However, Series A shares would generally continue to qualify for QSBS gain exclusion, all else being equal.
Considerations for Holding QSBS in Partnerships
Sec. 1202(g)(2) provides that stock will qualify as QSBS in the hands of a partnership for noncorporate partners so long as that partner was a partner in the partnership when the stock was purchased and at all times thereafter, until disposition of the QSBS. A noncorporate partner may be eligible for QSBS gain exclusion so long as the gain allocated to the partner is based on the partner's percentage interest in the partnership at the time the partnership acquired the QSBS (Sec. 1202(g)(3)). For this purpose, the law does not provide a clear definition of "interest."
Alternative Deferral When Holding Period Not Met
Taxpayers that do not meet the five-year holding period requirement but otherwise hold QSBS may opt to defer some or all of the federal gain on the sale of the stock by reinvesting the proceeds into other QSBS. To benefit from this gain deferral under Sec. 1045, the investor must have owned the QSBS for more than six months on the date of sale and reinvest some or all of the proceeds from the sale into newly acquired QSBS within 60 days of the sale of the prior QSBS.
The holding period and adjusted tax basis from the original shares will roll over into the newly acquired QSBS, effectively deferring the federal income tax recognition event.
Though the issue is beyond the scope of this item, it is important to note that recapitalizations of the underlying small business corporation within a specific time frame from the original issuance could negatively affect the QSBS determination.
Additionally, although this potential planning opportunity may lead to significant federal tax savings, many states, including California, do not follow federal income tax treatment of QSBS under Sec. 1202.
With capital gains rates higher than in years past, opportunities to defer, limit, or eliminate capital gain income may be extremely attractive. Thus, investors may wish to analyze their underlying portfolio holdings for opportunities to identify and exclude gain from the sale of QSBS on longer-term holdings or defer gains on shorter-term QSBS holdings.
Alex Brosseau is a senior manager in the Tax Policy Group of Deloitte Tax LLP’s Washington National Tax office.
For additional information about these items, contact Mr. Brosseau at 202-661-4532 or firstname.lastname@example.org.
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