On January 2, 2013, President Obama signed into law the American Taxpayer Relief Act of 2012 (H.R. 8) (the Act) to avert certain tax increases set to take effect in 2013. The Act included, among many other provisions, an extension of the temporary 100 percent exclusion (subject to per-issuer limitations) from gross income of gain derived from qualified small business stock (QSBS) held for more than five years, so long as such stock was purchased after December 31, 2011 and before January 1, 2014. The 100 percent exclusion is an attempt to encourage investment in new ventures, small businesses and specialized small business investment companies.
Before 2009, Code Section 1202 provided for the exclusion of 50 percent of a non-corporate taxpayer’s gain from QSBS (60 percent for gain attributable to QSBS in certain tax-favored areas). The American Recovery and Reinvestment Act of 2009 increased the exclusion to 75 percent for any QSBS acquired after Feb. 17, 2009 and before Sept. 28, 2010. Because the exclusion in all cases was based on a 28 percent rate (as opposed to the 15 percent capital gains rate in effect), the 50 percent exclusion resulted in a 14 percent effective tax rate and the 75 percent exclusion resulted in a 7 percent effective tax rate. However, for purposes of calculating alternative minimum tax (AMT), a percentage of the excluded gain was a preference item, and, thus, included in income for AMT purposes. As a consequence, the benefits provided under Section 1202 were in many cases not worth the administrative burden of qualifying for them.
The Small Business Jobs Act of 2010 expanded the exclusion and provided that for QSBS acquired after Sept. 27, 2010 and before Jan. 1, 2011:
the gain exclusion for QSBS for regular tax purposes is increased to 100 percent, and
no AMT preference will be applicable to the excluded gain for QSBS.
Accordingly, the modifications of Code Section 1202 in 2010 finally provided for a 100 percent exclusion of gain (subject to per issuer limitations) for QSBS acquired after September 27, 2010 and on or before December 31, 2011. Congress believed this exclusion provided an appropriate incentive for investors in small businesses, and it extended this 100 percent income and AMT exclusion in the Tax Relief, Unemployment Insurance Reauthorization, and Jobs Creation Act of 2010 to acquisitions of QSBS occurring before January 1, 2012.
The Act continues this policy, and further extends the 100 percent income and AMT exclusions for QSBS acquired after December 31, 2011 and before January 1, 2014.
For QSBS acquired on or after January 1, 2014, the 50 percent exclusion will be back in force and the AMT preference inclusion will again apply. (And, of course, for QSBS acquired after enactment of Section 1202 and before February 17, 2009, the 50 percent exclusion will continue to apply and for QSBS acquired on or after February 17, 2009 and before September 27, 2010, the 75 percent exclusion will continue to apply. The AMT preference inclusion also will continue to apply in those cases.)
The same per-issuer limitation as applied to the 50 percent and 75 percent exclusion remains applicable to the 100 percent exclusion: for any one taxpayer the maximum amount of eligible gain with respect to the stock of a single issuer is the greater of $10 million or 10 times the taxpayer’s basis in the stock of the issuing corporation.
The Act also added an interesting rule for determining when stock is acquired for purposes of applying the 75 percent and 100 percent exclusions. This rule appears to provide that where stock is acquired in a transaction in which the taxpayer’s holding period includes the holding period of the taxpayer in other property or another person’s holding period in the stock itself, the stock is treated as acquired not on the date of the taxpayer’s legal acquisition of the stock, but rather on the first date that is relevant in determining the taxpayer’s holding period in the stock. Accordingly, taxpayers should be aware that not all “legal” acquisitions of QSBS after September 27, 2010 will constitute acquisitions for purposes of these exclusions.
The Section 1202 gain exclusion is claimed on the tax return filed for the year of the disposition of the QSBS stock. It is generally reported by (i) entering the entire gain realized on the sale in the long-term capital gains section of Schedule D, and (ii) entering “Section 1202 Exclusion” directly below the line on which you report the gain along with the amount of the allowable exclusion as a negative amount in column (a).
While it may not have been worth the effort to demonstrate stock qualification in the past, it may now make sense to seek the necessary information for qualification from companies.
What Is QSBS?
To qualify as QSBS, stock must meet the following two requirements:
It must be stock (warrants do not themselves qualify, but exercise of a warrant for stock is an acquisition) acquired at its original issuance for money, property (other than corporate stock) or services provided to the issuing corporation (provided the services are not as an underwriter of the stock). In the case of stock acquired for services, whether or not the 100 percent exclusion applies is generally based on the date the stock is issued and not necessarily when the services are performed. Note that certain redemptions of QSBS before or after the issuance of the stock may deprive the newly issued stock of QSBS status (see below).
The corporation issuing the stock must be a qualified small business (QSB).
What Impact Do Redemptions Have on the Original Issuance Requirement?
Redemptions by the corporation from the taxpayer or a related person within the four-year period starting two years before the taxpayer’s or related person’s acquisition of the QSBS will disqualify the stock. Thus, the non-redemption period begins two years before and ends two years after the issuance of the stock to the taxpayer or related person. This is to encourage long-term investment. Additionally, “significant” redemptions by the QSB from shareholders (not just the taxpayer and his related persons) that occur within the two-year period starting one year before the acquisition of the QSBS (i.e., one year before until one year after that acquisition), will also disqualify the stock. Redemptions are “significant” if they constitute more than 5 percent of the aggregate value of the QSB’s stock.
For these purposes, a redemption includes any transaction treated as a redemption pursuant to Code Section 304(a). It is at times difficult for companies to comply with these requirements as well as to produce the necessary information regarding stock ownership and stock transfers within the requisite four- or two-year period (a taxpayer should certainly know if stock has been redeemed from him, but may not always know whether stock has been redeemed from a related person or other shareholder). Minority stockholders often are not in a position to access the company’s information. Until 2010, it arguably has not been worth the effort. Now, however, individual investors may want to negotiate covenants restricting disqualifying redemptions in their stockholder or investor rights agreements.
What Is a QSB?
A QSB is a C corporation, the aggregate gross assets of which must not have exceeded $50 million at any time before the issuance of the stock to the applicable taxpayer or related person, as well as immediately after the issuance of the stock, and which satisfies the active business requirement. Any increase in the corporation’s aggregate gross assets after this testing time (immediately after issuance) is not relevant.
The active business requirement is met if (1) the corporation uses at least 80 percent of its assets, measured by value, in the active conduct of one or more qualified trades or businesses, and (2) the corporation is an eligible corporation. A qualified trade or business generally does not include a service business, an oil and gas business, a banking or investing business, a motel business, or similar businesses. Start-up, R&D, and in-house research activities may be treated as used in an active trade or business, regardless of whether they have generated any gross income. Assets held for working capital needs also may be treated as used in the active conduct of a qualified business. There are limitations on the amount of portfolio stock and real estate that a corporation may hold and still be considered engaged in the active conduct of a qualified trade or business. An eligible corporation means a domestic corporation and does not include a DISC, RIC, REIT, REMIC or FASIT, or a cooperative.
How Does Section 1202 Apply in the Partnership Context?
If a partnership disposes of QSB stock that it has held for more than five years, the gain from the disposition is allocated among all the partners, and the partners who held an interest in the partnership from the time it acquired the stock to the time it disposed of the stock are eligible for exclusion on their proportionate share of the partnership’s gain. In determining a partner’s proportionate share of the partnership’s gain, the partner’s ownership interest at the time the stock was acquired must be used. This requirement is meant to prevent taxpayers from increasing benefits under Code Section 1202 over time. However, it may not be clear how a partner’s ownership interest is to be measured.
The application of the proportionate share rule dictated in Code Section 1202 in connection with the substantial economic effect rule of Code Section 704(b), as well as the governing allocation provisions in a partnership agreement, may create confusion and uncertainty. Certain partnership structures may allow for closer tracking of the QSBS ownership. For a discussion of the application of these rules to investment funds, please see Pepper's Funds Services Alert (October 8, 2010), upon which this summary is largely based.
Since 2010, the exclusion under Code Section 1202 has become a more meaningful tax planning tool, and, as a result of the Act, will continue to be so through 2013. QSBs might benefit from seeking out individual and non-corporate investors and likewise such investors may benefit from seeking out investment opportunities in QSBs. QSBs, however, should be aware that investors may request protections that would require agreement by QSBs to restrict redemptions in the appropriate time period after a stock acquisition (as well as demonstrate redemption history). Although more challenging through a partnership, Code Section 1202 opportunities should not be ignored, but rather should be analyzed to determine whether the Act’s extension of the 100 percent exclusion can benefit non-corporate investors in the partnership.