Tax Manager Matthew Weber, CPA, MAcc recently published an article for our newest KROST Quarterly Magazine: The Financial Services Issue titled “The Qualified Small Business Stock Gain Exclusion”.
If you sell stock that has appreciated in value, then you must recognize a taxable capital gain. Sounds straightforward, right? While that may be true most of the time, it is in the best interest of investors in small corporations and startups to become familiar with the tax benefits of the Qualified Small Business Stock (QSBS) gain exclusion.
If you are a non-corporate investor who acquired stock of a domestic C corporation directly from that corporation for money, property (other than stock), or certain services and have held that stock for more than five years, then you may be eligible for the QSBS gain exclusion under Internal Revenue Code Section 1202 when you sell that stock.
NON-CORPORATE INVESTORS CAN EXCLUDE CAPITAL GAINS FROM SALES OF QSBS
Depending on the acquisition date of the QSBS, non-corporate investors may exclude 50%, 75%, or 100% of the gain they realize on the disposition of QSBS issued after August 10, 1993, and held for more than five years. If the QSBS is from stock options, then the acquisition date is the exercise date, not the date of grant.
PERCENTAGE GAIN EXCLUSION BY ACQUISITION DATE
There is a cumulative limit on the gain from a single issuer that a taxpayer may exclude. Eligible gain from any one corporate issuer in any given tax year is taken into account only to the extent that it does not exceed the greater of:
- $10 million reduced by the aggregate amount of eligible gain taken into account by the taxpayer in prior years
from the same issuer, or;
- 10 times the adjusted basis of all qualified stock of the issuer that the taxpayer disposed of during the tax year. Additions to the basis are disregarded. This limitation can severely restrict the tax benefit of this provision in the event of a truly substantial windfall.
The $10 million limitation is applied on a shareholder-by-shareholder basis and any property contributed to the issuing corporation is its fair market value as of the contribution date. Married taxpayers filing separately have $5 million of eligible gain for each spouse.
It is important to note that both before and immediately after the date of issuance, a qualified small business corporation’s aggregate gross assets cannot exceed $50 million. Since the date of issuance, at least 80% (by value) of the corporation’s assets must have been used in the active conduct of one or more qualified trades or businesses.
Stock issued to a taxpayer cannot qualify for the exclusion if the issuing corporation purchases (directly or indirectly) any of its own stock from the taxpayer or persons related to the taxpayer within the four-year period beginning two years before the date of issuance. A safe-harbor de minimis amount can be redeemed without rendering the stock ineligible for the exclusion. The aggregate amount paid for the stock by the issuing corporation in such redemptions cannot exceed $10,000 or more than 2% of the stock held by the taxpayer and all related persons.
Stock will also not qualify for the exclusion if the issuing corporation engages in a “significant redemption.” A redemption is significant if the corporation, within a two-year period beginning one year before the issuance of the stock, redeems stock with an aggregate value exceeding 5% of the aggregate value of all the corporation stock. A de minimis exception applies if either the aggregate amount paid for all stock redeemed during the two-year period does not exceed $10,000 or no more than 2% of all outstanding stock.
Another opportunity for QSBS holders is provided by Internal Revenue Code Section 1045. A rollover option is available to QSBS holders that have held the stock for at least six months. Section 1045 allows a QSBS holder to rollover gains into replacement QSBS. The taxpayer must invest in the replacement QSBS within 60 days of the sale of the QSBS. Thetaxpayer will only recognize gain to the extent that the amount realized on the sale exceeds the cost of any QSBS purchased during the replacement period (less any portion of that cost previously taken into account under Section 1045). The amount of the deferred gain reduces the basis in the replacement QSBS, so any gain not recognized currently is deferred, not excluded.
There is no specific language in either Section 1202 or Section 1045 that indicates the two sections are mutually exclusive. Therefore, it is reasonable to conclude that a taxpayer who exceeds the dollar limits of Section 1202 could use Section 1045 to defer the excess gain. Obviously, the QSBS gain would have to meet the longer five-year holding period for the Section 1202 exclusion.
The Protecting Americans from Tax Hikes Act of 2015 (“PATH Act”) made several tax breaks permanent, including the QSBS gain exclusion. The law made permanent the exclusion of 100% of the gain on the sale or exchange of QSBS acquired after September 27, 2010, and held for more than five years. The PATH Act also permanently extended the rule that eliminates the 100% excluded QSBS gain as a preference item for AMT purposes. In addition, QSBS gain excluded from income is not subject to the 3.8% Net Investment Income Tax (additional tax on capital gains, interest, dividends, and other investment income), which is imposed on high-income taxpayers. It is critical that founders, investors, and employees who wish to utilize QSBS engage the right professionals for advice. In addition, it is prudent for corporations to document the QSBS status of their newly issued stock at each round of financing.
About the Author
Matthew Weber, CPA, MAcc, Director
Tax, Financial Services Sector, Hospitality
Matthew Weber is a Director at KROST. He has been with the firm’s tax practice since July 2015 and has worked in public accounting since 2010. Before joining the firm, Matthew was a Tax Manager at PricewaterhouseCoopers in Los Angeles. Matthew’s areas of expertise include federal and multi-state tax compliance and consulting for individuals, corporations, and partnerships. » Full Bio