Excluding 100% of Gain From the Sale of Qualified Small Business Stock Acquired in 2013

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If you own a small business, it may be easier to raise money in 2013. This is because, among the favorable tax breaks included under the American Taxpayer Relief Act (the “2012 Act”), there is a temporary extension of the 100% exclusion of gain arising from the sale of certain qualified small business stock (“QSBS”). Under the right circumstances, for QSBS acquired during 2013, 100% of the gain from the sale of such stock will not be taxed, including under the alternative minimum tax (“AMT”) rules. With an effective tax rate of 0%, this is an extremely favorable tax provision and benefits both investors and businesses looking to raise equity. And, it comes at a time when the effective tax rates on gains from the sale of capital assets have increased for certain “high-income taxpayers” from 15% to 23.8% (after taking into account a new 3.8% tax on net investment income discussed below). But, as with most tax breaks, there are limitations and exceptions to this general rule. As such, businesses looking to raise equity should familiarize themselves with the QSBS requirements.

Small businesses should expect that investors seeking to benefit from the QSBS rules will conduct due diligence about the company’s history. Such due diligence will typically include determining the historical gross assets of the issuing corporation and understanding how the corporation’s assets are used in connection with one or more qualifying trades or businesses. Further, the investors will be looking for representations from the issuing corporation, both historical and forward looking, to allow the investor to conclude that the issued stock is and will continue to qualify as QSBS. 

I. A Brief History of QSBS

Special treatment available for taxpayers selling QSBS has existed since 1993.[1] At that time, the maximum long-term capital gain rate for individuals was 28%.  When first enacted, taxpayers were permitted to exclude 50% of their gain from the sale of QSBS. As a result, the tax rate on the sale of qualifying QSBS was effectively 14%.[2] In this respect, the legislation strongly favored investing in QSBS.

In the following years, although long-term capital gain rates began to decrease, the 28% rate applicable to QSBS remained unchanged. As a result, the benefit of investing in QSBS was similarly reduced.[3]  The benefit of investing in QSBS reached an all-time low beginning in 2003, when the maximum long-term capital gain rate was reduced to 15%, resulting in just a 1% benefit when comparing the effective rate for gains from the sale of QSBS to the effective rate from the sale of non-QSBS. For many investors, after taking into account the required five-year holding period and other applicable limitations, including the application of the AMT to gain from the sale of QSBS, investing in QSBS hardly seemed worth the effort.[4]

In reaction to the difficult economic times beginning in early 2008, legislative efforts were taken to stimulate investments in QSBS by excluding more QSBS-gain from being subject to the 28% tax.[5]

In late 2010, a change in law allowed taxpayers to exclude 100% of their gain from the sale of QSBS acquired between September 28, 2010 and December 31, 2011.[6] Significantly, this change in law also provided that such gain would not be subject to the AMT. As a result, the benefit of investing in QSBS during that time period could be calculated as the difference between (i) a 15% tax rate generally applicable to long-term capital gains, and (ii) a 0% effective tax rate applicable to gain from the sale of such QSBS.

If the 2012 Act had not been signed into law, then the 100% exclusion would have automatically expired and the original 50% exclusion, and application of the AMT, would have applied to gain from the sale of QSBS acquired during 2012 and thereafter. The 2012 Act retroactively[7] extended the 100% exclusion rules for two years through December 31, 2013. As a result, 100% of the gain from the sale of QSBS is excluded from income for all purposes, including for the purposes of the AMT rules.

II. QSBS Acquired in 2013

The 2012 Act increased long-term capital gains rates for certain taxpayers. For example, married taxpayers filing jointly and who have ordinary income in excess of $450,000 are subject to a 20% long-term capital gain rate.[8]

Furthermore, beginning in 2013, certain higher income taxpayers must pay an additional 3.8% Medicare tax on their net investment income (the “Net Investment Income Tax”), which includes capital gains.[9]  In certain instances, the combination of these changes could result in a 23.8% effective tax rate on long-term capital gains. Therefore, the benefit of investing in QSBS during 2013 can be as high as 23.8% of the gain upon the sale of the QSBS.

III. QSBS Acquired in 2014

The current law automatically sunsets at the end of 2013.  As a result, for QSBS acquired on or after January 1, 2014, only 50% of gain from the sale of such stock is excluded for purposes of computing a taxpayer’s federal income tax.  For taxpayers subject to the 3.8% Net Investment Income Tax, the effective tax rate on the gains from the sale of qualifying QSBS would be 15.9%, calculated as 50% of the sum of the 28% rate and the 3.8% rate.  In addition, the AMT preference will apply to the sale of such QSBS such that 7% of the excluded gain is treated as a tax preference item for purposes of calculating a taxpayer’s AMT. As a result, for taxpayers subject to the highest capital gains rate[10] and the Net Investment Income Tax, the benefit of investing in QSBS in 2014 (as opposed to investing in stock that does not so qualify) could be as high as 7.9% of the gain from the eventual sale of the QSBS, which is the difference between a 23.8% effective tax rate on long-term capital gains[11] and a 15.9% effective tax rate (and possibly higher to the extent the AMT applies) on gains from the sale of such QSBS. 

Thus, although investing in QSBS after 2013 will continue to provide a more tax efficient alternative than investing in other stock, investing in QSBS in 2013 is much more beneficial.

IV. What is QSBS and Who Can Benefit from These Rules?

       A. Eligible Taxpayers

As a general matter, only individuals qualify for the QSBS exclusion rules. In addition, individuals who hold QSBS indirectly through an interest in a flow-thru entity, e.g., a partnership, limited liability company or S corporation, may also qualify for the exclusion if certain requirements are met.[12]

       B. What is QSBS?

In general, to qualify as QSBS, the following requirements must be satisfied:

  • The stock must be that of a domestic C corporation;
  • The stock must be acquired in an original issuance from the corporation in exchange for money, property or services;
  • The aggregate gross assets of the corporation could not have exceeded $50 million at any time between August 10, 1993 and immediately following the issuance (i.e., the calculation takes into account amounts received from the issuance);
  • At least 80% of the corporation’s assets, determined by value, must be used in the active conduct of a trade or business.[13]   This test must be met during substantially all of the time the investor owns the stock;[14] and
  • The taxpayer must hold the stock for more than five years before selling it.[15]

The “aggregate gross asset” test has two parts. First, the “aggregate gross assets” of the corporation (and any predecessor corporation) may not exceed $50 million at any time after August 9, 1993, and before the stock was issued.  Second, the aggregate gross assets of the corporation immediately after the issuance of the stock, including the consideration received by the corporation for the stock, may not exceed $50 million. The term “aggregate gross assets” refers to the sum of the money and the adjusted basis of all other property of the corporation. So, basically, for the corporation to be able to issue qualified small business stock, the adjusted basis of the corporation’s assets plus its cash on hand cannot have, on any day since August 9, 1993, exceeded $50 million.  And, the corporation will be limited in how much qualified small business stock it can now issue based on the difference between $50 million and the sum of the total cash on hand and the adjusted basis of the corporation’s other assets at the time of the issuance. There is a special rule if property other than cash was contributed to the corporation. Further, a controlled group of corporations, consisting of a parent and any more than 50%-owned subsidiaries, are treated as one corporation for the purposes of the aggregate gross assets test.

A corporation is not deemed to be involved in the active conduct of a trade or business in connection with: (i) the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial sciences, performing arts, consulting, athletics, or financial or brokerage services, (ii) banking, insurance, finance, leasing or investing, (iii) a hotel or restaurant business, (iv) a farming or mineral extraction business, or (v) anything similar to the businesses or fields listed above. Further, a corporation is not treated as being involved in the active conduct of a trade or business if more than 10% of the corporation's assets, by value, consist of real property that is not used in a qualified trade or business, and the ownership of, dealing in, or renting of real property is not treated as the active conduct of a qualified trade or business.[16] Further, start-up, research or development activities in connection with a “future qualified trade or business” qualify as an active trade or business even if the activities presently generate no income.[17]

       C. Limitations

It is important to recognize the limitations of investing in QSBS.  For example, the amount of gain from the sale of QSBS eligible for exclusion is limited to the greater of $10 million, or 10 times the taxpayer’s adjusted basis of all qualified stock of the issuer disposed of during the year.

In addition, special rules exist which, if applicable, could deny the benefits of QSBS.  For example, if a corporation redeems stock from a stockholder within the four-year period commencing two years prior to the issuance of the stock, the exclusion rules may no longer apply to that stockholder.  Similarly, if the corporation redeems a significant portion of its outstanding stock within the two-year period commencing one year prior to the issuance of the stock, the exclusion rules may no longer apply to any stockholder. 

Also, as one would suspect, there are special rules that deny the benefits of QSBS if the taxpayer (or a related party) takes an offsetting position relating to the QSBS before the end of the required five-year holding period. 

     V. Is it Worth it?

With respect to QSBS acquired during 2013, the ability to exclude from tax, including the AMT, 100% of the gain from the sale of a five-year investment is enticing indeed.  Of course, the analysis should not end there.  There are many other factors to consider before choosing to conduct business in C corporation form in order to qualify under the QSBS rules.  For example, both investors and the businesses seeking to attract equity need to consider whether it makes sense for the investment vehicle to be taxed as a C corporation, which is subject to both a corporate-level tax and a shareholder-level tax.[18] Further, upon the sale of the business, acquirers prefer to purchase assets rather than stock and will pay less for the business if the transaction is structured as a stock sale.  These are just two of many considerations that must be taken into account when deciding whether to convert an LLC or S corporation into a C corporation. There are many other tax considerations that may ultimately affect the net after tax IRR on an investor in a C corporation, all of which should be carefully analyzed before proceeding to form or convert into a C corporation. 

This article is by no means a substitute for careful tax planning; and taxpayers are strongly encouraged to consult with a tax professional familiar with these rules and the taxpayer’s particular situation.

[1] See, the Revenue Reconciliation Act of 1993. [back]

[2] For example, on $100 of gain from the sale of QSBS, only 50% would be subject to tax at a rate of 28% (i.e., $50 of gain, multiplied by a 28% tax rate, equals $14 of tax). [back]

[3] See, the Taxpayer Relief Act of 1997 and Code §1(h)(1) (reducing the long-term capital gain rate from 28% to 20%, but retaining, the 28% rate applicable to gain from the sale of QSBS stock).  As a result, the benefit of investing in QSBS could be calculated as the difference between (i) a 20% rate generally applicable to long-term capital gains, and (ii) a 14% effective tax rate applicable to gain from the sale of QSBS (i.e., 50% of the QSBS gain, multiplied by a 28% tax rate). [back]

[4] Compare (i) a 15% rate generally applicable to long-term capital gains and (ii) a 14% effective tax rate (or higher if the AMT applied) applicable to gain from the sale of QSBS.  In certain circumstances, if the issuing corporation was a qualified business under the Empowerment Zone Rules, then the amount of gain excludible was increased from 50% to 60%.  As a result, the effective tax rate applicable to gain from the sale of certain QSBS was 11.2% (i.e., 40% of gain, multiplied by a 28% tax rate). [back]

[5] See, the American Recovery and Reinvestment Act of 2009 (providing an exclusion of 75% of gain from the sale of QSBS acquired after February 17, 2009 and before September 28, 2010).  The result was an effective tax rate from the sale of such QSBS of 7% (i.e., 25% of such gain was subject to a 28% tax), which investors compared to the 15% rate generally applicable to long-term capital gains. [back]

[6] See, the Small Business Jobs Act of 2010, and the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. [back]

[7] The 2012 Act was signed into law in early January 2013.  Any QSBS acquired during 2012 was subject only to 50% exclusion rules. The 2012 Act reached back into 2012 and applied the 100% exclusion rules to QSBS acquired during 2012 and 2013. [back]

[8] For married taxpayers filing jointly, who earn less than $450,000, the maximum long-term capital gains rate remained unchanged at 15%. [back]

[9] This 3.8% tax is effective as of January 1, 2013, but was enacted pursuant to the Patient Protection and Affordable Care Act of 2010.  For these purposes, “higher income” means, for example, married taxpayers filing jointly with certain amounts of income that exceed $250,000. [back]

[10] For example, married taxpayers filing jointly, with $450,000, of income. [back]

[11] Calculated by adding the 20% long-term capital gain rate to the 3.8% Net Investment Income Tax. [back]

[12] The rules applicable to flow-thru entities are not addressed in this article. [back]

[13] Code § 1202(c)(2) and (e)(1). [back]

[14] Code § 1202(c)(2)(A). [back]

[15] An investor may qualify for the QSBS exclusion if, after six months, the investor sells his or her QSBS and, within 60 days, rolls over the investment into new QSBS which, when combined with the holding period of the original QSBS investment, is held by the investor for the required holding period.  See, Code §1045. [back]

[16] Code § 1202(e)(7). [back]

[17] Code § 1202(e)(2). [back]

[18] Assuming a corporate tax rate of 35% and a shareholder tax rate on qualified dividends of 15%, the effective tax rate on $100 of corporate profits which, after taxes, is distributed to its shareholder, is approximately 44.8% (i.e., $100 x 35% corporate tax rate leaves only $65 available for distribution as a qualified dividend, and $65 x 15% qualified dividend rate, leaves $55.20 after-tax proceeds for the investor).  The 3.8% Net Investment Income Tax may also apply to such dividends, resulting in an effective federal tax rate of 48.6%. [back]