Taxpayers have a short window in which to act if they want to take advantage of the Sec. 1202 provision that allows exclusion of 100% of the gain realized on the sale or exchange of qualified small business stock (QSBS). Unless the law is amended, for QSBS acquired after Dec. 31, 2013, the Sec. 1202 exclusion percentage will fall to 50%, and an alternative minimum tax (AMT) preference will further erode the exclusion’s advantages.
Currently, Sec. 1202 allows exclusion of 100% of the gain realized on the sale or exchange of QSBS for stock that is acquired after Sept. 27, 2010, and before Jan. 1, 2014, and held for more than five years. The exclusion applies to noncorporate taxpayers within certain tax-year limits.
In addition, the Sec. 57(a)(7) AMT preference for a portion of the gain excluded under Sec. 1202 does not apply to QSBS purchased within this period (Sec. 1202(a)(4)). Because the deadline for acquiring stock that will qualify for the more favorable treatment is rapidly approaching, investors should plan to complete any purchases of stock that could qualify as QSBS before the end of the year.
REQUIREMENTS UNDER SEC. 1202
Qualified Small Business Stock
Stock qualifies as QSBS only if it meets all of the following tests:
- It must be stock in a C corporation (i.e., not S corporation stock) originally issued after Aug. 10, 1993.
- As of the date the stock was issued, the corporation was a domestic C corporation with total gross assets of $50 million or less (a) at all times after Aug. 9, 1993, and before the stock was issued, and (b) immediately after the stock was issued. Gross assets include those of any predecessor of the corporation, and all corporations that are members of the same parent-subsidiary controlled group are treated as one corporation.
- In general, the taxpayer must have acquired the stock at its original issue (either directly or through an underwriter), either in exchange for money or other property or as compensation for services (other than as an underwriter) to the corporation.
- During “substantially all the time” (a term that is not defined in the statute or in IRS guidance) the taxpayer held the stock:
- The corporation was a C corporation;
- At least 80% of the value of the corporation’s assets was used in the “active conduct” of one or more qualified businesses; and
- The corporation was not a foreign corporation, domestic international sales corporation (DISC), former DISC, regulated investment company (RIC), real estate investment trust (REIT), real estate mortgage investment conduit (REMIC), cooperative, or a corporation that is eligible to make (or has a subsidiary that is eligible to make) a Sec. 936 election.
For each tax year, for each corporation in which the taxpayer sells or exchanges QSBS, the amount of gain eligible for the exclusion cannot exceed the greater of:
- $10 million ($5 million for married persons filing separately), less the total amount of eligible gain (i.e., gain on the sale or exchange of QSBS held for more than five years) taken into account under the Sec. 1202(a) rules by the taxpayer with respect to dispositions of stock issued by the corporation in all earlier tax years; or
- 10 times the taxpayer’s total adjusted basis in QSBS of the corporation disposed of by the taxpayer in the tax year (Sec. 1202(b)(1)).
Note that the first limit is expressed as a dollar cap of $10 million ($5 million for separate filers) and also is a cumulative cap for dispositions of stock of the same corporation. By contrast, the second limit does not have a dollar cap—instead, the limit is calculated using the basis in the QSBS shares—and is an annual limit. Thus, by stretching out sales of QSBS of the same corporation, a taxpayer may be able to exclude more than $10 million of gain.
Active Business Requirement
At least 80% of the value of the corporation’s assets must be used in the “active conduct” of one or more qualified businesses. Assets used in the active conduct of a qualified business include:
Assets used in certain activities relating to future qualified businesses, without regard to whether the corporation has any gross income from these activities at the time this rule is applied. Those activities are:
Sec. 195(c)(1)(A) startup activities;
Activities that result in paying or incurring qualifying research and experimental expenditures under Sec. 174; and
Activities relating to in-house research expenses (Sec. 1202(e)(2));
Assets held to meet the “reasonably required working capital needs” of a qualifying business, and assets held for investment that are reasonably expected to be used within two years to finance research and experimentation in a qualified business or to finance increases in the working capital needs of the business (Sec. 1202(e)(6)); and
The rights to computer software that produces active business computer software royalties as defined in Sec. 543(d)(1) (Sec. 1202(e)(8)).
A corporation is treated as failing to meet the active conduct requirement for any period during which:
- More than 10% of the value of its assets in excess of its liabilities consists of stock or securities in other corporations that are not subsidiaries, other than working capital assets (Sec. 1202(e)(5)(B)); or
- More than 10% of the total value of its assets consists of real property that is not used in the active conduct of a qualified business (for this purpose, owning, dealing in, or renting real property is not considered to be the active conduct of a qualified business) (Sec. 1202(e)(7)).
For QSBS purposes, a qualified business cannot be a business involving services performed in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services or any other trade or business whose principal asset is the reputation or skill of one or more employees (Sec. 1202(e)(3)).
No statute, regulation, or congressional committee report gives insight as to Congress’s intent regarding the intangible human qualities “reputation” or “skill.” Thus, it is unclear which trades or businesses will fail the qualified business test as a result of this language, or which more-specific characteristics of any given trade or business would cause a business to fail this test.
Current law provides an exception to the treatment of a portion of the gain excluded under Sec. 1202 as an AMT tax preference for QSBS acquired after Sept. 24, 2010, and before Jan. 1, 2014 (Sec. 1202(a)(4)(C)). For stock acquired on or after Jan. 1, 2014, the AMT preference will apply to gain excluded under Sec. 1202.
NET INVESTMENT INCOME TAX
Starting in 2013, a 3.8% surtax applies to the net investment income of taxpayers with modified adjusted gross income exceeding a specific threshold ($250,000 for married taxpayers filing jointly, $125,000 for married taxpayers filing separately, and $200,000 for other individual taxpayers). The gain excluded under Sec. 1202 presumably should not be subject to the net investment income tax because that tax applies to net gain only to the extent it is taken into account in computing taxable income (Sec. 1411(c)(1)(A)(iii)).
Individual taxpayers who acquire stock before the end of this year that qualifies as QSBS when it is sold will be able to exclude 100% of the gain on the sale from both regular tax and AMT. However, gain from the sale of QSBS acquired in 2014 may qualify for only a 50% gain exclusion, and a portion of the gain may be an AMT preference item. Therefore, investors should plan to complete purchases of stock that could qualify as QSBS before the end of 2013.
Qualified small business stock (QSBS) acquired before the end of 2013 and held for five years before sale qualifies for a 100% exclusion from income of any capital gain upon its sale, for regular and alternative minimum tax purposes.
To qualify as QSBS, the stock must be issued by a C corporation with total gross assets of $50 million or less at all times and at least 80% of whose assets are used in an active trade or business.
To qualify to exclude the gain, a taxpayer must be a noncorporate shareholder who has held the stock since it was issued. There are also limits on the amount of stock that can be excluded.
QSBS is even more valuable now that the capital gain tax rate is higher for high-income taxpayers. The gain from the sale of QSBS is also not subject to the new 3.8% tax on net investment income.
Taxpayers have a narrow window to acquire stock that qualifies for the 100% exclusion (the stock must be held for five years before it is sold regardless). They must acquire the stock by Dec. 31, 2013.
Laura Jean Kreissl ( firstname.lastname@example.org ) is an assistant professor, and Darlene Pulliam ( email@example.com ) is Regents Professor and McCray Professor of Accounting. Both teach in the College of Business, at West Texas A&M University, Canyon, Texas.
To comment on this article or to suggest an idea for another article, contact Sally P. Schreiber, senior editor, at firstname.lastname@example.org or 919-402-4828.
“Tax Practice Corner: A Limited-Time Opportunity for Small Business Stock,” Dec. 2009, page 71
Adviser’s Guide to the Tax Consequences of the Purchase and Sale of a Business, Second Edition (#091025)
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