Taxpayers may be surprised to learn that the appreciated stock they hold could, upon sale, be eligible for a full gain exclusion. This means that no federal income tax is owed after the stock is sold.
Generally, this qualified full small business stock gain exclusion occurs when a taxpayer other than a corporation holds what is called “qualified small business stock” (QSBS) as defined under section 1202 of the Internal Revenue Code. Although the basic rules and requirements for holding QSBS are relatively straightforward, the application of these requirements can sometimes create uncertainties and potential pitfalls for the unwary.
Basic Requirements for Full Gain Exclusion
Here are some of the QSBS exemption requirements when it comes to full gain exclusion:
- C corporation: The stock at issue must be stock in a business entity (like a state law corporation or LLC) classified as a C corporation for federal tax purposes. Note that LLCs and other state law entities classified as partnerships for tax purposes can potentially change their tax classification to C corporations for QSBS planning purposes (although the holding period requirements begin only upon the date of conversion).
- Original Issuance: A taxpayer must acquire QSBS at “original issuance” (after August 10, 1993) in exchange for a capital contribution or services. This means a taxpayer cannot purchase QSBS from another taxpayer to avoid being taxed for capital gain.
- Five-year hold: A taxpayer must hold QSBS for more than five years before selling in order to achieve the qualified small business stock gain exclusion.
- Qualified small business: The C corporation must be a qualified small business, as defined under section 1202, during substantially all of the taxpayer’s QSBS holding period.
- Gain Exclusion: The amount of gain exclusion is equal to the greater of $10 million or 10 times the basis in the taxpayer’s QSBS.
- Generally, 50% of the gain can be excluded for QSBS issued after August 10, 1993, and before February 18, 2009; 75% of the gain can be excluded for QSBS issued after February 17, 2009, and on or before September 27, 2010; and 100% for QSBS issued after September 27, 2010.
- Note the alternative minimum tax can apply to gain from the sale of QSBS issued on or before September 27, 2010.
The Definition of a Qualified Small Business
One frequent issue concerns whether the corporation meets the qualified definition for the small business stock exclusion. A qualified small business must satisfy multiple statutory tests, including:
- Not having aggregate gross assets exceeding $50 million at all times since inception up to, and immediately after, the issuance of the QSBS exclusion.
- At least 80 percent (by value) of the corporation’s assets are used in the active conduct of a qualified trade or business (and avoiding limitations on real estate holdings and holding cash, portfolio stock, securities and other similar financial assets).
A qualified trade or business is defined by exclusion, meaning the statute only tells taxpayers what types of businesses are not qualified. Generally, the following service-based businesses are not qualified (note there are also other nonqualified businesses listed in the statute not discussed in this insight):
“...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.”
To date, no regulations have been promulgated under section 1202 concerning the definition of a qualified business, leaving some taxpayers with significant uncertainty as to whether their business qualifies. For example, it appears a business is nonqualified if consulting services represent more than 20 percent of its value. With no precise definition of what it means to perform consulting services, a taxpayer and advisers would have to look to case law and other analogous authorities for support to firmly establish whether a company can qualify for the small business stock gain exclusion.
Unfortunately, the government states a taxpayer cannot rely upon another code section (for example, section 199A) and its accompanying regulations for support. Section 199A refers to section 1202 when defining a qualified business for purposes of the 20% deduction for qualified business income. The government has issued extensive regulations under section 199A but specifically stated those regulations do not apply to areas outside of section 199A, including section 1202.
One possible prudent approach individuals can take is to file a private letter ruling request (a PLR) asking the IRS to rule upon whether a business is qualified for section 1202 purposes. We have experience with this process and are happy to discuss the specifics to provide further help and information on the qualified small business stock gain exclusion.
Traps for the Unwary
As with many tax benefits, there are significant “traps for the unwary” that can jeopardize the qualified small business stock gain exclusion. Here are a few traps to watch for:
- Redemption transactions can disqualify both the single issuance of QSBS and all issuances of QSBS.
- Mergers and divisions can cause a corporation to no longer be qualified.
- The sale of QSBS before the five-year hold results in no gain exclusion, although a taxpayer can roll gain from the sale of QSBS into other QSBS within 60 days of sale (pursuant to section 1045).
- QSBS can be transferred by gift, at death, or from a partnership to a partner, but other transfers generally result in the transferee no longer holding QSBS.
- Partnerships can hold QSBS, with partners eligible for the gain exclusion when the partnership sells the QSBS, so long as the partners held their partnership interest at the time the partnership acquired the QSBS at original issuance and provided all other requirements are met (including that the eligible partners’ interests did not change after the QSBS issuance).
- Not all states with an income tax fully conform to section 1202, including California. Taxpayers subject to a state income tax should consult with their tax adviser on state specific issues.
What You Need to Know about Qualified Small Business Stock
QSBS is a powerful planning tool that can produce significant tax savings when investing. For instance, a single investor forming a qualified business with $49.9 million of capital could exclude up to $499 million of gain (assuming all other requirements are met) upon sale.
Yet holding and maintaining QSBS requires foresight and diligence, and taxpayers should consider consulting with their tax adviser before forming a qualified business and before selling QSBS. This knowledge is critical as you prepare for the future of your business.