Under Section 1202, the qualified small business stock (QSBS) gain exclusion provides significant tax benefits by allowing the exclusion of up to 100% of taxable gain from the sale of QSBS. If the Biden administration’s plan to increase long-term capital gains rates becomes a reality, qualifying for the QSBS gain exclusion is likely to take on greater importance. However, without regard to whether capital gain tax rates increase under the Biden administration, the QSBS exclusion should be a key consideration for investors, founders, and qualifying businesses looking to raise capital.
Qualified Small Business Stock (QSBS)
To qualify as QSBS, the stock must be C corporation stock (S corporation stock does not qualify). The stock must be acquired from the C corporation (not from another stockholder except in limited circumstances) in exchange for money, other Section 1202 stock, other property (excluding non-Section1202 stock), or services provided to the corporation. The corporation must meet certain active business requirements (based on asset use) during substantially all of the taxpayer’s stock holding period, and the aggregate gross assets of the corporation (and certain subsidiaries) must not have exceeded $50M1 at any time before or immediately after the taxpayer’s receipt of the stock. Stock held in corporations conducting certain industry-specific trades or businesses (e.g., health, law, engineering, architecture, accounting, etc.) and consulting (or other personal services) trades or businesses will not qualify as QSBS.
Gain Exclusion
The gain exclusion applies to non-corporate taxpayers with respect to the sale of QSBS held directly by them (or held indirectly through a partnership or S corporation) for more than five years. The amount of gain that may be excluded by a taxpayer (e.g., an individual stockholder) for federal income tax purposes (as well as for net investment income tax and alternative minimum tax purposes) is the greater of $10M or 10x the aggregate “adjusted stock basis”2 of QSBS sold during the taxable year. The exclusion amount varies depending on when the stock is acquired.
- QSBS acquired between 8/11/1993 – 2/17/2009 (50% Gain Exclusion);
- QSBS acquired between 2/18/2009 – 9/27/2010 (75% Gain Exclusion); and
- QSBS acquired after 9/27/2010 (100% Gain Exclusion).
For example, if the QSBS sold was acquired during the 50% gain exclusion period, the taxpayer would be permitted to exclude 50% of the eligible gain up to a maximum excluded amount equal to the greater of $5M (50% of $10M) or 50% of 10x the aggregate “adjusted stock basis” of QSBS sold during the taxable year. The additional amount of gain that would have been excluded under Section 1202 if the 100% gain exclusion (rather than the 50% gain exclusion) applied would be taxed at a 28% federal income tax rate. Therefore, assuming the applicable cap is 50% of $10M, the effective federal income tax rate for $10M of eligible gain recognized on the sale of QSBS acquired during the 50% gain exclusion period is 14% (i.e., no tax on 50% of the gain and tax at 28% on the remaining 50%).
With respect to the exclusion of QSBS gain at the state level, it is important to determine whether the applicable state follows federal tax law with respect to Section 1202. Qualification for the exclusion at the federal level does not necessarily mean the taxpayer will also be able to exclude the gain at the state level.
When Should You Consider or Reconsider Section 1202
Founders, early-stage investors and start-up businesses should consider whether setting up their operations in a C corporation in order to take advantage of QSBS is appropriate. If the business is not originally set up as a C corporation, businesses may be able to convert to a C corporation structure and issue QSBS at the time of conversion. Investors should consider whether it is possible to receive QSBS in the context of an investment in an existing business. Also, Section 1202 needs consideration with respect to existing shareholders and/or purchasers in the context of M&A transactions.
Certain Circumstances Warranting Special Attention
Stock redemptions may result in the failure of stock issued within two years before or two years after the redemption to qualify as QSBS. Transfers of stock from a stockholder to a partnership (including an LLC taxed as a partnership) will result in loss of QSBS treatment for the transferred stock. Also, special rules and requirements apply to QSBS issued by the corporation to a partnership (including an LLC taxed as a partnership) or an S Corporation.
Rollover of Certain Gain
If QSBS held for more than six months is sold and the proceeds are reinvested in separate QSBS within 60 days following the sale, the gain resulting from the sale may be deferred.
Conclusion
Section 1202 may provide substantial tax benefits in connection with the sale of QSBS and should be considered in the context of a number of transactions and scenarios. Section 1202 will likely take on even greater importance given the possibility of capital gain tax rate increases.
If you have any questions about this legal update, please do not hesitate to reach out to the authors or any of your contacts at Morris, Manning & Martin, LLP.
[1] Special (generally taxpayer friendly) rules apply in determining the amount of aggregate gross assets for Section 1202 purposes.
[2] Special (generally taxpayer friendly) rules apply for determining “adjusted stock basis” for Section 1202 purposes.
