Tax planning for year-end; expiration of the 100% tax exemption for gain on QSBS

Just a reminder that the temporary 100% exclusion for Federal capital gains tax on the sale of “qualified small business stock” (“QSBS”), under Section 1202 of the IRS regulations, is set to expire at the end of calendar year 2013.

The QSBS tax exemption was originally enacted to incentivize investment in certain small businesses by providing (non-corporate) investors the opportunity to exclude all or a portion of their gains from Federal capital gains tax in certain circumstances.

In order to qualify as QSBS, stock must be purchased from a domestic C corporation that (i) is engaged in an active trade or business (as defined by the IRS regulations) and (ii) has gross assets which do not exceed $50 million (measured when the stock is purchased). Further, in order to qualify for the tax exemption, the investor must hold the qualified stock for at least five years from the date of purchase. In addition, the timing of an investor’s purchase of the qualified stock will impact the amount excluded from Federal capital gains tax that may later apply when the stock is ultimately sold, according to the following percentages:

  • 50% exclusion: a holder of qualifying stock acquired after August 10, 1993 and on or before February 17, 2009 may be eligible for a 50% exclusion from Federal capital gains tax (if the stock is held for more than five years).
  • 75% exclusion: a holder of qualifying stock acquired after February 17, 2009 and on or before September 27, 2010 may be eligible for a 75% exclusion from Federal capital gains tax (if the stock is held for more than five years).
  • 100% exclusion: a holder of qualifying stock acquired after September 27, 2010 and before January 1, 2014 may be eligible for a 100% exclusion from Federal capital gains tax (if the stock is held for more than five years).

President Obama’s FY 2014 Administrative Budget includes a proposal for a permanent extension of the QSBS gain exclusion. However, as tax reform negotiations and pressure to reduce the Federal deficit continue, there may likely be more desire to eliminate special tax preferences (or so-called tax “loopholes”) than to raise tax rates. The question is whether the QSBS tax exemption will be swept into the tax loopholes category or whether it will continue to be viewed as a way to spur investments in small businesses. Only time will tell if Obama’s proposed extension becomes law or if it will be traded-away for other items during tax reform negotiations. The important thing to keep in mind is that the QSBS tax exemption (as it applies to new investments) will expire unless there is legislation to extend the provision.

In terms of tax planning for the remainder of 2013, investors considering an investment in a startup before December 31, 2013 may want to factor into their decision the type of security that they purchase. In other words, investments made in the form of convertible / bridge debt will not qualify for the 100% QSBS tax exemption unless such debt is actually converted to stock before January 1, 2014 or the QSBS tax exemption is extended. Although the QSBS tax rules have been extended in the past (and notwithstanding proposals to make these rules permanent), there can be no assurance that such extensions will continue in the future.

If you are interested in more detail, here is the full text of the QSBS Section 1202 tax exemption.