The American Recovery and Reinvestment Act of 2009 (ARRA) increased the exclusion amount for qualified small business stock (QSBS) from 50% to 75% (IRC § 1202). In addition, QSBS is currently subject to a lower inclusion rate for gains subject to the alternative minimum tax (AMT) under section 57(a)(7). However, these two rate reductions will soon expire.
QSBS can be an attractive part of a tax strategy because you can roll over proceeds from a sale into new QSBS while deferring gain under section 1045. Even so, for years, the tax advantages of QSBS have been offset by their less attractive conditions, such as a five-year holding period for the gain exclusion and 28% tax rate, especially after rates were cut to 15% for most long-term capital gains. But with the higher exclusion rate yielding a low effective tax rate of 7% (28% x 25% of gain), and the prospect for a rise in capital gains tax rates, tax advisers should learn now how QSBS can be a valuable part of a client’s tax strategy.
QUALIFIED SMALL BUSINESS STOCK
A qualified small business is a C corporation with assets of $50 million or less. At least 80% of its assets must be used in the active conduct of a trade or business other than certain professional services, athletics, performing arts, banking and financial enterprises, hotels, motels or restaurants and other activities listed in section 1202(e). To qualify for gain exclusion, QSBS must be acquired by original issue and held by the taxpayer (which may not be a corporation) for at least five years. The amount of gain eligible for exclusion is limited under section 1202(b). If purchased between Feb. 18, 2009, and Dec. 31, 2010, it can qualify for the 75% exclusion.
A percentage of the gain excluded under regular tax is an AMT preference item, that is, it is included in AMT income. For QSBS sold before Dec. 31, 2010, the percentage is 7%. For QSBS sold after 2010 that had been purchased since 2000, the percentage increases to 28% and to 42% for stock acquired during or before 2000.
Taxpayers (other than corporations) can also defer the tax on sale of QSBS held for at least six months with an IRC § 1045 election if the stock is replaced within 60 days and all the sale proceeds are reinvested in new QSBS. The tax is due (or partially excluded under section 1202) when the replacement stock is finally sold.
BUSINESS OWNERS AND INVESTORS
The section 1045 election is beneficial for business owners considering selling their company. The business owner can defer any taxable gains by using the sale proceeds to start a new business. Since the business owner controls the timing of the sale and reinvestment, it is more likely the rollover period will be met. Flexibility is a hallmark of QSBS in other ways, as well. For example, investors don’t necessarily have to pay cash for QSBS. They can receive it for services to a company (section 1202(c)(1)(B)(ii)). Retired executives and former entrepreneurs, for example, besides providing capital can provide guidance to the company. Investors can work for the company as a consultant or in management.
Owners of a partnership or other pass-through entity may share in the tax benefits of QSBS as a pass-through item, including proportionate shares of gain exclusion (section 1202(g)). Owners also can make the section 1045 election on their share of QSBS gains. For example, XYZ partnership sells QSBS on March 1, 2010, at a gain. Partner X can defer the gain by purchasing replacement stock on March 31, 2010. If X purchases QSBS that is equal to or greater than his/her share of the sale proceeds, the gain is deferred.
It also works the other way. Assume Investor A has a gain from the sale of QSBS on April 1, 2010. Investor A contributes the sale proceeds to form the ABC partnership. ABC uses all contributed capital to purchase QSBS stock on April 15, 2010. The gain is also deferred because the QSBS was purchased within 60 days and A was a partner at the time of purchase. In addition, an individual can use QSBS of a partnership as replacement stock (Treas. Reg. § 1.1045-1(c)(1)). A partnership is therefore a preferred entity for holding QSBS.
In determining whether to recommend a section 1045 election, consider the following:
- Screen your client database for taxpayers with occupations such as retired executive, investor or business owner.
- Red-flag QSBS purchases in the client file for future action.
- Ask clients about QSBS purchases in a year-end tax questionnaire.
By Tom Prieto, CPA, MBT, (firstname.lastname@example.org) an adjunct professor at American Jewish University in Los Angeles.