CSG Law Alert: Qualified Small Business Stock Owners Can Save Millions in Taxes
Originally enacted in 1993 to incentivize investment in certain start-ups and small businesses, Section 1202 of the Internal Revenue Code (the “Code”) provides significant tax planning opportunities for owners of qualified small business stock (“QSBS”). Depending on when the QSBS was acquired, taxpayers may be able to exclude up to 100% of the gain (capped at the greater of $10 million or 10 times the QSBS’ adjusted basis) from the sale of QSBS after holding such QSBS for more than five years.
In general, QSBS is stock obtained via an original issuance after August 11, 1993, in a qualified small business (“QSB”) that satisfies the active business requirement for substantially all of the taxpayer’s holding period. A QSB is a domestic C corporation that agrees to submit reports as required by the Secretary of the Treasury and whose aggregate gross assets are no greater than $50 million both before and immediately after the issuance. With limited exceptions, the QSBS must have been acquired in an original issuance in exchange for money or property—not including stock—or as compensation for services, other than underwriting services provided in connection with the issuance. One exception to this rule is if the taxpayer receives QSBS via certain tax-free exchanges, such as a gift from a separate taxpayer who already satisfied the original issuance requirement.
To satisfy the active business requirement, a QSB must be an “eligible corporation” and at least 80% of its aggregate gross assets must be used in a “qualified trade or business.” An eligible corporation is any domestic corporation other than a domestic international sales corporation, regulated investment company, real estate investment trust, real estate mortgage investment conduit, or cooperative. A certain amount of working capital assets and computer software royalties may count towards the 80% asset test: however, a QSB will be disqualified for any period in which (1) greater than 10% of its assets consist of real property not used in a qualified trade or business; or (2) greater than 10% of its assets (in excess of liabilities and not including working capital assets) are comprised of stocks or securities in non-subsidiary corporations.
What is a Qualified Trade or Business?
A qualified trade or business is defined by exclusion as any trade or business other than the following:
- Any trade or business involving the performance of services in the 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 of such trade or business is the reputation or skill of 1 or more of its employees,
- Any banking, insurance, financing, leasing, investing, or similar business,
- Any farming business (including the business of raising or harvesting trees),
- Any business involving the production or extraction of products of a character with respect to which a deduction is allowable under section 613 or 613A, and
- Any business of operating a hotel, motel, restaurant, or similar business.
Section 1202 and its limited regulations do not provide definitions for the above terms and the IRS has indicated that it will define these terms broadly to limit taxpayers’ eligibility for gain exclusion. Therefore, whether a taxpayer’s business will be eligible for Section 1202’s benefits will depend on a focused analysis of all the facts and circumstances.
While QSBS must be held for more than five years before being eligible for gain-exclusion, Section 1045 allows taxpayers to take advantage of Section 1202’s benefits in the future by using the sale proceeds to purchase new QSBS within 60 days of the sale. No gain will be recognized to the extent that the sale proceeds do not exceed the cost of the newly acquired QSBS (accounting for any previous Section 1045 transactions applied towards said QSBS). Instead, the gain will “rollover” into the new QSBS which will have a basis equal to the purchase price, reduced by the unrecognized gain from the earlier sale. To qualify under Section 1045, taxpayers must (1) not be a corporation; (2) sell QSBS; (3) have held the QSBS for more than six months prior to the sale; and (4) elect Section 1045 treatment in their tax filings. Finally, Section 1045 treatment is also available to partnerships and partners that comply with additional rules found in regulations.
Sections 1202 and 1045 offer potentially rewarding tax planning opportunities to holders of QSBS. While this overview highlights the sections’ main elements, taxpayers must carefully consider their individual circumstances when applying the complex (and often subjective) rules and exceptions.
If you would like to discuss your personal situation and options, please contact your CSG Law attorney.