Congress Extends 100% Gain Exclusion for Small Business Stock

by Morgan Lewis
Contact

Favorable tax treatment applies to certain acquisitions of qualified small business stock in 2012 and 2013 and may influence choice-of-entity decisions.

In a little-noticed provision of the American Taxpayer Relief Act of 2012 (the Act), Congress extended the effective tax rate of 0% on the sale of qualified small business stock (also known as Section 1202 Stock) for a second time. The Act modifies Section 1202 of the Internal Revenue Code to provide that 100% of the eligible gain received by an individual taxpayer from the sale of qualified small business stock acquired after September 27, 2010, and before January 1, 2014, and held for more than five years, may be excluded from the taxpayer's income for federal tax purposes. In addition, the excluded gain under this temporary provision remains a nonpreference item for alternative minimum tax (AMT) purposes. Congress originally provided for the 100% gain exclusion in 2010 and later extended such treatment to qualified small business stock acquired in 2011, but it did not provide for such treatment with respect to stock purchased in 2012.[1] Thus, the Act both extends favorable tax treatment for such stock acquired in 2013 and retroactively applies such tax treatment to such stock acquired in 2012. As there is no guarantee that Congress will extend the 100% gain exclusion on small business stock acquired after 2013, investors planning to acquire qualified small business stock should consider doing so during 2013 to secure the benefits of the Act.

Scope of the Gain Exclusion

The gain exclusion is available only with respect to "qualified small business stock," which is stock of a C corporation that, at the time of the stock's issuance, has gross assets of $50 million or less. In general, the stock must be acquired by the investor at the time of the original issuance. Moreover, for substantially all of the time during which the taxpayer holds the stock, the corporation must be actively engaged in a qualifying trade or business. A qualifying trade or business can be any business other than banking, farming, natural resource extraction/production, or certain service businesses. Specifically, a business engaged in consulting, engineering, or leasing activities cannot be a qualifying trade or business.

The amount of gain that is eligible for exclusion under this provision is equal to the greater of (i) 10 times the taxpayer's basis in the stock or (ii) $10 million. Gain is eligible for exclusion only if it is derived by an individual, directly or indirectly, through an entity treated as a partnership for tax purposes. Special rules apply where the gain on qualified small business stock is allocable to an individual through a partnership, as well as for the calculation of tax basis for the purpose of the gain exclusion limitation. Gain above the applicable threshold amount is subject to capital gains tax and is generally subject to the 3.8% Medicare tax that applies to capital gains from the sales of stock beginning in 2013. Since gain below this threshold is not taken into account in computing taxable income, such gain is excluded from "net investment income," which is subject to the new 3.8% Medicare tax.

Generally, 50% of eligible gain on the sale of qualified small business stock purchased outside the specified window may be excluded from the taxpayer's income. In addition, some of the excluded gain is ordinarily treated as an AMT preference item and is therefore added back into the taxpayer's AMT income, which further reduces the benefit of the exclusion.

Implications

Although only temporary, the extension of the 100% gain exclusion on qualified small business stock under the Act may take on an increased role in choice-of-entity decisions between C corporations and "pass through" entities, such as limited liability companies (LLCs) or S corporations. From a tax perspective, pass-through vehicles have historically been the preferred choice of entity for most start-up businesses for several reasons, including the ability to distribute operational earnings with only one level of tax (at the owner level). More importantly, a pass-through entity also generally permits the tax-efficient sale of a business in a transaction structure that will allow the buyer to "step up" the asset tax basis of the purchased business and amortize its purchase price for tax purposes. While the size of this premium will vary greatly depending on the tax and investment profile of the buyer, it is often a key choice of entity consideration. However, the new 3.8% Medicare tax will increase the role of Section 1202 as an offsetting tax consideration in favor of C corporations as the choice of entity for those taxpayers who believe they can take advantage of the extended 100% gain exclusion for sales of Section 1202 Stock. As discussed above, the 3.8% Medicare tax does not apply to capital gains on qualified small business stock eligible for exclusion under Section 1202, whereas the 3.8% Medicare tax will apply to most capital gains generated by sales of equity in a pass-through entity (assuming the Medicare tax income thresholds are met by the selling owner).

Legislative proposals also may tip the needle in favor of a C corporation choice of entity for those taxpayers who believe they can take advantage of Section 1202. Currently, proposed tax reforms suggest the possibility of a broader shift in policy toward encouraging the use of C corporations, as opposed to pass-through entities. For instance, one major proposed reform intended to make the U.S. corporate tax system more competitive with tax systems of other countries involves reducing corporate income tax rates to as low as 25%, broadening the "base" for corporate tax revenues, and shifting to a "territorial," rather than worldwide, system of taxation. The future of these proposals is uncertain, but it is likely that the tax benefits of pass-through entities will not be expanded and may actually be limited. When combined with non-tax commercial reasons for choosing a C corporation, such as the general preference of venture capitalists to invest in C corporations and the use of C corporations for those businesses contemplating an IPO exit, these legislative proposals and Section 1202 may make the C corporation a more desirable choice of entity for some business owners.


[1]. Read more about the favorable tax treatment for qualified small business stock in our October 27, 2010, LawFlash, "New Law Temporarily Expands Favorable Tax Treatment of Certain Small Business Stock, " available here, and our December 23, 2010, LawFlash, "Favorable Tax Treatment of Certain Small Business Stock Extended for One Year," available here.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morgan Lewis | Attorney Advertising

Written by:

Morgan Lewis
Contact
more
less

Morgan Lewis on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Privacy Policy (Updated: October 8, 2015):
hide

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.

Security

JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at info@jdsupra.com. In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at: info@jdsupra.com.

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.