Your Guide to the Qualified Small Business Stock Exclusion (article)

Your Guide to the Qualified Small Business Stock Exclusion (article)

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Section 1202 Benefits

Proprietors and venture capitalists analyze many factors underlying prospective ownership in a business. The business structure’s tax efficiency is a main consideration, where “double taxation” for C corporations applies to corporate earnings and to shareholder dividends. Since as far back as 1993, Internal Revenue Code Section 1202 has provided qualifying C corporations with opportunities to mitigate this double tax, but fluctuations in the benefit offered and the capital gains tax rates have limited its use. The new tax law commonly known as the Tax Cuts and Jobs Act (TCJA) may make the Qualified Small Business Stock (QSBS) exclusion under Section 1202 more appealing for small businesses, however. To take advantage of the QSBS exclusion, both businesses and their investors need to be aware of how it works, its potential limitations, and the planning opportunities available.

What Is the Qualified Small Business Stock Exclusion?

Nearly 30 years ago, Congress passed the Revenue Reconciliation Act of 1993, creating the first version of Section 1202.  Under the current version of Section 1202, a domestic small business operating as a C corporation can issue QSBS to qualifying investors who can then sell the stock tax-free after five years.

The QSBS exclusion is designed to incentivize investments in small businesses, so the C corporation issuing the stock must meet the definition of a Qualified Small Business. A Qualified Small Business is a C corporation whose gross assets do not exceed $50 million at any time between Aug. 9, 1993 (the effective date of the Revenue Reconciliation Act of 1993) and the date of issuance for the stock, and immediately thereafter. Once a C corporation has gross assets exceeding $50 million, it is permanently prohibited from issuing stock that qualifies for the QSBS exclusion.

A Qualified Small Business must use at least 80 percent of its assets in a qualifying trade or business. A number of businesses are excluded, including:

  • Trades or businesses involving professional services where the service relies on the skill of its employees, including health, law, engineering, accounting, consulting, and financial services
  • Banking, insurance, financing or investing
  • Most farming businesses
  • Oil and gas extraction
  • Hospitality, including hotel, motel, restaurants or similar businesses

Additionally, a Qualified Small Business must remain a C corporation for substantially all of the stockholder’s holding period.

Which Types of Investors Benefit from QSBS?

Investors also must meet certain requirements in order to take advantage of the capital gains exclusion. The investor cannot be a C corporation. The investor must acquire the QSBS in an orginal issuance from the Qualified Small Business in exchange for money, property, or services. The original issuance requirement includes:

  • Exercising stock options or warrants or through a conversion of convertible debt
  • Stock options acquired as a gift or estate benefit
  • Stock options acquired as a distribution from a partnership under certain parameters

How Have the Benefits under Section 1202 Evolved?

Both long-term capital gains rates and the Section 1202 gain exclusion percentage have changed since the passage of the Revenue Reconciliation Act of 1993. These fluctuations, which have at times made the QSBS exemption less attractive for investors, may be to blame for the under-use or misunderstanding of this benefit.

In 1993, long-term capital gains were taxed at the same rates as ordinary income. The top rate was 28 percent. Section 1202 permitted qualifying investors to exclude up to 50 percent of their long-term capital gains on the sale or exchange of QSBS occurring after the requisite 5-year-holding period. The earliest the 50 percent exclusion applied was for gains realized after Aug. 10, 1998. The effective tax rate for capital gains on QSBS sales or exchanges was 14 percent.

Before 1998 came to pass, however, the long-term capital gains tax rate was reduced to 20 percent, and concurrently a provision was added to Section 1202 that retained a 28 percent capital gains rate for the portion of the gain not subject to the QSBS exclusion. Therefore, the effective tax rate on QSBS sales or exchanges was still 14 percent. Under this dynamic, the lower capital gains tax rates for regular sales or exchanges, paired with the alternative minimum tax adjustment for excluded QSBS gains made the QSBS benefit less appealing for investors. In 2003, the capital gains tax was reduced again to 15 percent, and at that point, the QSBS exclusion offered next to no benefit.

Several years later, Congress tried to reenergize the Section 1202 benefit by bumping up the percentage of QSBS gains that could be excluded to 75 percent in 2009, and then 100 percent in 2010. Concurrent with the temporary change to the 100 percent exemption, the alternative minimum tax adjustment was eliminated. The temporary provision then became a permanent tax benefit under the Protecting Americans from Tax Hikes Act of 2015.

The 100 percent QSBS exclusion, together with other TCJA changes involving corporate tax rates, could lead to more C corporation business structures and may bring new life to the QSBS exclusion.

QSBS Limitations

Before engaging full throttle into qualifying QSBS investments, investors should evaluate some of the nuances under Section 1202 that could limit the full QSBS benefit.

Redemptions Rule

Section 1202 comes with specific rules for redemptions. A Qualified Small Business that purchases more than a de minimis amount of its own stock during a two-year period of time surrounding a stock issuance, or that redeems over 5 percent of the aggregate value of all the company’s stock during a one-year period of time surrounding a stock issuance would not be eligible for the QSBS exclusion.

There are certain exceptions to the redemptions rule, including cases where the company automatically buys back stock from a departing employee.

On the other hand, a complete liquidation of a QSBS in exchange for stock may also qualify for the QSBS treatment. The 21 percent corporate tax rate under the TCJA could apply to the deemed sale of business assets, but the gain generated by the subsequent liquidating distribution of cash paid to the QSBS shareholders would be tax-free. This arrangement would provide for a single layer of tax to the seller at the 21 percent rate, while providing a buyer with tax basis on the acquired business assets equal to the full purchase price.

Contributing to Partnership Rule

Investors can receive QSBS from a partnership that has an investment in a Qualified Small Business when the following conditions are met:

  • The partnership was the original recipient of the stock;
  • The partner receiving the QSBS has been a partner since the date the partnership acquired the QSBS, and is a partner through the distribution date; and
  • The partner’s share of the QSBS interest cannot exceed the partner’s share in the partnership.

Hedging Transactions

Transactions that involve a hedge may not qualify for the QSBS benefit unless the seller in the transaction held the QSBS for five years before the transaction took place.

Planning Opportunities

Traditionally, pass-through entities have been the entity structure of choice for small businesses and start-ups. The new tax law changes that logic up by reducing the corporate tax rate to 21 percent. As discussed, businesses may want to consider the C corporation structure and whether the benefits under Section 1202 will apply.

Small businesses or investors that do not qualify for the QSBS exclusion may still have some planning options available to limit the capital gains tax consequences on the sale or exchange of their stock. For instance, Section 1045 provides roll-over opportunities for investors to defer the gain on QSBS that is held for at least six months.

Consult with a Tax Advisor

A tax professional experienced with the opportunities under Section 1202 can help both businesses and their investors maximize benefits under the QSBS exclusion. It is important for investors to be familiar with these benefits, particularly in situations where different tax professionals are involved with personal and business tax returns.

For more information, please contact us.

2019 Business Tax Planning Supplement


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CBIZ MHM is the brand name for CBIZ MHM, LLC, a national professional services company providing tax, financial advisory and consulting services to individuals, tax-exempt organizations and a wide range of publicly-traded and privately-held companies. CBIZ MHM, LLC is a fully owned subsidiary of CBIZ, Inc. (NYSE: CBZ).

Your Guide to the Qualified Small Business Stock Exclusion (article)~/Portals/0/PackFlashItemImages/WebReady/Section-1202-Benefits-thumb.jpghttps://www.cbiz.com/Portals/0/liquidImages/WebReady/Section-1202-Benefits-thumb.jpgProprietors and venture capitalists analyze many factors underlying prospective ownership in a business....2019-03-26T13:40:59-05:00

Proprietors and venture capitalists analyze many factors underlying prospective ownership in a business.

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