With the prospect of an increase in capital gain income tax rates looming on the horizon, what could be more welcome than an exclusion of 100% of gain from income? That is exactly what Section 1202 of the Internal Revenue Code provides to certain sellers of qualified small business stock.
Exclusion of Gain
Section 1202 permits taxpayers, other than corporations, to exclude 100% of any gain from the sale of qualified small business stock ("QSB stock") held by the taxpayer for more than five years. The 100% exclusion applies to QSB stock acquired on or after September 28, 2010, and that vintage QSB stock is the focus of this Alert.
(A note on QSB stock issued before September 28, 2010: Section 1202 provides for a 50% exclusion for QSB stock acquired on or after August 11, 1993 and before February 18, 2009 and a 75% exclusion for QSB stock acquired on or after February 18, 2009 and before September 28, 2010. There is a 28% capital gain rate with respect to such QSB stock on the percentage of gain not excluded under Section 1202 and also an alternative minimum tax component to the exclusion.)
Gain from sales of QSB stock that is excluded under Section 1202 is also excluded from the tax base of the 3.8% tax on net investment income.
There is a dollar limit, to be sure, and there are several technical requirements to be met, but when the exclusion is available it can be very valuable to the taxpayer selling QSB stock.
The dollar limit is an annual per-issuer limit on the amount of the taxpayer’s gain which may be excluded. The limit is the greater of (1) $10 million or (2) ten times the basis of the QSB stock sold by the taxpayer during the year. (The $10 million limit is adjusted to take into account the taxpayer’s prior sales of the issuer’s QSB stock.)
Thus, for example, a taxpayer may parlay a $500,000 investment into a $10 million gain exclusion or a $2 million investment into a $20 million gain exclusion.
Qualified Small Business Stock
What is QSB stock? It is stock of a C (not S) corporation originally issued after August 10, 1993, with respect to which certain requirements are met.
- QSB. On the date the stock is issued, the corporation must be a qualified small business ("QSB").
- Original Issue. The taxpayer must generally acquire the stock at its original issue from the corporation. The acquisition must be for money or other property (not including stock) or for services provided to the corporation. (There are limited exceptions for acquisitions of stock in the same corporation through stock conversions and for acquisitions of stock in certain tax-free situations, including gifts, bequests, partnership distributions and corporate incorporations and reorganizations.) To buttress the original issue requirement, Section 1202 provides that certain redemptions of its stock by the issuing corporation will result in the taxpayer’s stock not being QSB stock.
- Active Business. During substantially all of the taxpayer’s holding period for the stock the C corporation must meet the active business requirement spelled out in Section 1202.
Qualified Small Business
Among the requirements for QSB stock is one that the issuing corporation must be a QSB on the stock’s issue date. What is a QSB? A QSB is a domestic C corporation meeting certain assets tests.
- At all times on or after August 10, 1993 and before the issuance of the stock, the corporation’s aggregate gross assets must not have exceeded $50 million; and
- Immediately after the issuance of the stock, the aggregate gross assets of the corporation (taking the amounts received in the issuance into account) do not exceed $50 million.
For these purposes, "aggregate gross assets" means the amount of cash and the aggregate adjusted bases of other property held by the corporation. A special rule provides that in this calculation the basis of property contributed to the corporation in kind (determined immediately after the contribution) equals the fair market value of such property at the time of the contribution.
After the corporation meets the assets test for a stock issue it does not need to keep its assets below $50 million (unless it is planning to do another QSB stock issue). A QSB does not have to stay "small."
Active Business Requirement
Which brings us to Section 1202’s active business requirement. It is not a matter of a snapshot in time. The corporation must meet the requirement for substantially all of the period during which the taxpayer owns the stock. The corporation meets the active business requirement if:
- At least 80% (by value) of the corporation’s assets are used in the active conduct of one or more qualified trades or businesses; and
- The corporation is an eligible corporation; that is, not a DISC, a former DISC, a RIC, a REIT, a REMIC or a cooperative.
The corporation’s working capital and short-term investments are, within limits, treated as used in the active conduct of a qualified trade or business.
For purposes of the active business requirement, a look-thru rule generally applies to the corporation’s subsidiaries ("subsidiaries" being corporations in which the corporation owns more than 50% of combined voting power or more than 50% of the stock value). In addition, Section 1202 says that a corporation will not meet the active business requirement whenever more than 10% of the value of its net assets consists of stock or securities in other corporations which are not its "subsidiaries" (other than permitted working capital or short-term investments).
There is also a limit on passive real estate holdings. A corporation will not meet the active business requirement whenever more than 10% of the total value of its assets is real property that is not used in the active conduct of a trade or business.
A special rule treats rights to computer software that produces active business computer royalties as an asset used in the active conduct of a trade or business.
If you have read this far, the author hopes what follows is not disappointing. It is in the context of the requirement that the corporation be engaged in the active conduct of a "qualified trade or business" that a winnowing out occurs under Section 1202.
Certain trades or business cannot be qualified trades or businesses. Here is the list:
- Performance of services in fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services or any trade or business where the principal asset is the reputation or skill of one or more of the employees;
- Banking, insurance, financing, leasing, investing or similar business;
- Any business involving the production or extraction of products for which percentage depletion is allowed; or
- Operating a hotel, motel, restaurant or similar business.
While the list of disfavored businesses is long, there are still many other businesses that will pass muster as qualified trades or businesses under Section 1202.
Taxpayers with interests in pass-thru entities, such as partnerships or S corporations, may take advantage of Section 1202 to exclude gain on qualifying sales of stock held by the pass-thru entity. (The statute treats the QSB stock as if it were held by an individual to get around the nominal prohibition on corporate ownership.) There are, however, conditions. The pass-thru entity must have held the stock for more than five years before the sale, and the taxpayer must have held the interest in the pass-thru entity on the date the pass-thru entity acquired the stock and at all times thereafter before the pass-thru entity sold the stock.
Special Basis Rules
In certain situations, a taxpayer may find that there are extra steps involved in determining the amount of the taxpayer’s gain that may be excluded.
A taxpayer’s basis in QSB stock may be calculated differently for purposes of determining how much gain may be excluded under Section 1202 than under the regular tax rules for determining gain. If a taxpayer transfers property (other than money or stock) to the issuing corporation in exchange for stock, the basis of that stock to the taxpayer (for purposes of Section 1202) must be no less than the fair market value of the property exchanged. A similar rule applies in the case of contributions of property to the capital of the corporation after the stock has been issued. These rules limit the gain eligible for exclusion to gains that accrue after the property is transferred to the corporation.
A taxpayer who limits his risk with respect to QSB stock may lose the benefits of Section 1202. If the taxpayer has "an offsetting short position" with respect to any QSB stock, the exclusion of Section 1202 will not apply unless the taxpayer held the QSB stock for more than five years on the first day there was such a short position and the taxpayer elects to recognize gain as if the QSB stock were sold on that day for its fair market value.
A taxpayer has an offsetting short position if:
- The taxpayer (or a related person) has made a short sale of substantially identical property;
- The taxpayer (or a related person) has acquired an option to sell substantially identical property at a fixed price; or
- To the extent provided in the regulations, the taxpayer (or a related person) has entered into any other transaction that substantially reduces the risk of loss from holding such QSB stock.
The exclusion of gain provided by Section 1202 can be very valuable to a taxpayer selling QSB stock, but first there must be a QSB. The statute’s technical requirements mean planning is required when a qualified business is organized, while it is operated and before its stock is sold in order to have the best chance to secure the exclusion.
Even if no planning has been done ahead of time, when a taxpayer has sold stock in a C corporation engaged in a qualified business, it will still often be worthwhile to determine whether the stock is QSB stock under Section 1202.