How the Tax Reform Law Revitalizes the Qualified Small Business Stock Incentive for PE and VC Investors (article)
Qualifying C corporations have long offered tax benefits to their investors under Section 1202 of the Internal Revenue Code (IRC), but fluctuations in the benefit and the capital gains tax have limited investors’ Section 1202 use. Tax reform under the law commonly known as the Tax Cuts and Jobs Act (TCJA) may make the Qualified Small Business Stock (QSBS) Incentive in Section 1202 benefit more appealing for private equity (PE) and venture capital (VC) groups. To take advantage of the QSBS Incentive, PE and VC investors need to be aware of how it works, its potential limitations, and the planning opportunities available.
What Is the Qualified Small Business Stock Incentive?
Nearly 30 years ago, Congress passed the Revenue Reconciliation Act of 1993, which among other things, led to the creation of Section 1202. Under Section 1202, a domestic C corporation can issue QSBS if certain conditions are met.
The QSBS Incentive is designed to attract investments in small businesses, and as such the C corporation issuing the stock must meet the definition of a Qualified Small Business (QSB). The corporation’s gross assets must not exceed $50 million between Aug. 9, 1993 (the effective date of the Revenue Reconciliation Act of 1993) and the issuance of the stock. Immediately after the date of issuance, the aggregate gross assets of the corporation—including the consideration received for the issuance of the stock—must not exceed $50 million. Once a C corporation exceeds the $50 million of gross assets threshold, all future issuances will fail to qualify as QSBS.
The C corporation must also conduct qualifying trade or business activities in order to be treated as a QSB. In order to meet this requirement, 80% of the corporation’s assets must be used in a qualifying trade or business. A number of business types are excluded from QSB status, including:
- Trades or businesses involving professional services where the service relies on the skill of its employees, including health, law, engineering, accounting, consulting, financial services
- Banking, insurance, financing or investing
- Most farming businesses
- Oil and gas extraction
- Hospitality, including hotel, motel, restaurants or similar businesses
The C corporation must remain a C corporation for substantially all of the stockholder’s holding period.
In exchange, qualifying investors can exclude a portion of the gain from their investment in QSBS if the stock is held for at least five years. The QSBS exclusion is limited by the higher of $10 million or 10 times the original basis of the QSBS on an investment-by-investment basis. The ceiling for investors is reduced by the aggregate amount of eligible gain taken in prior years, and also faces a per-issuer limitation. Leftover gain that is not excludable from taxable income is taxed at a maximum rate of 28% instead of the 20% for regular long-term capital gains.
As a note, the excludable portion of gain on QSBS can be transferred to non-QSB stock in a tax-free reorganization or recapitalization prior to IPO. QSBS also retains its status upon distribution to partners/members.
Another interesting fact to note is that the alternative minimum tax (AMT) preference for the portion of the gain excluded does not apply to QSBS purchased after Sept. 27, 2010.
How PE and VC Investors Benefit from the QSBS Incentive
The potential gain exclusion available under Section 1202 depends on when the QSBS was acquired. If QSBS was acquired on or before Feb. 17, 2009, the gain exclusion is 50%. If QSBS was acquired after Feb. 17, 2009, but before Sept. 27, 2010, the gain exclusion is 75%. QSBS acquired after Sept. 27, 2001 has a 100% gain exclusion.
Certain requirements must be met in order for PE and VC investors to take advantage of the applicable capital gains exclusion. First, Section 1202 does not apply to corporate taxpayers. Second, the shares of potential QSB stock must be acquired directly from the QSB in an original issuance transaction. 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
PE and VC Investors can receive the QSBS Incentive from a fund that is structured as a partnership when the following conditions are met:
- The partner receiving the QSB stock was a partner in the fund at the time the QSBS was purchased, and
- The partner cannot increase his/her share of QSBS owned by the partnership.
How Have the Benefits under Section 1202 Evolved?
Long-term capital gains rates and the percentage of gain exclusion available under Section 1202 have changed since the passage of the Revenue Reconciliation Act of 1993. These fluctuations, which have at times made the QSBS Incentive less attractive for investors, may be among the culprits for why the benefit has not been heavily used or well-understood.
In 1993, long-term capital gains were taxed at the same rates as ordinary income. The top rate was 28%. Section 1202 permitted qualifying investors to exclude up to 50% of their long-term capital gains at the end of their five-year-holding period. The earliest the 50% exclusion applied was for gains after Aug. 10, 1998. Under the initial benefit, the effective tax rate for QSB capital gains was 14%.
Before 1998 came around, however, the long-term capital gains was reduced to 20%, and a provision was added to Section 1202 that made the 50% of capital gains not subject to the exclusion taxable at a 28% rate. The effective tax rate on QSBS was still 14%, but the lower regular capital gains tax and the AMT adjustment for QSB gain exclusion made the QSB option less appealing for investors. In 2003, the capital gains tax was reduced again to 15%, and at that point, the QSBS Incentive was pretty much irrelevant.
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% in 2009 and then 100% in 2010. Additionally, with the 100% exclusion, there is no more AMT adjustment. The full QSBS exclusion became a permanent tax benefit under the Protecting Americans from Tax Hikes Act.
The 100% permanent exclusion, and the TCJA changes that could potentially lead to more businesses opting for C corporation entity structures may bring new life to the QSBS Incentive.
Applying the QSBS Incentive
The decision to take the QSBS Incentive is made at the partner level. The partnership should include a footnote with the information necessary for the partners to determine the amount of gain allocated from the sale of QSBS, including:
- Date of the acquisition/sale
- Basis of QSB
- Sale price of QSB
- Gain allocation with carry and portion attributable to capital interest
Partnerships should also obtain data and representations from the portfolio companies related to specific provisions of Section 1202, including:
- Original issuance/redemptions
- Tax basis of assets at time of investment
- Active conduct
- C corporation
Partnerships that receive the QSBS Incentive will have some complexity to work through, because there is no definition of interest in Section 1220 and there are no regulations for Section 1202. The regulations that have been issued for the deferral of gain on QSBS (in Section 1045) limit the deferral based on partners’ smallest percentage interest in partnership capital. But, without clear definition around 1202, the meaning of interest is open to some interpretation. A tax advisor may be able to help clarify general partner allocations tax positions.
Before rushing full throttle into qualifying C corporation investments, PE and VC investors may want to evaluate some of the nuances in Section 1202 that could potentially limit them from receiving the full QSBS benefit.
Section 1202 comes with specific rules for redemptions. Investors in a Qualified Small Business that purchases more than a de minimis amount of its own stock and the total value of this stock exceeds 5% of all the company’s stock would not be eligible for the QSBS Incentive.
There are certain exceptions to the redemptions rule, including cases where the company automatically buys back stock from a departing employee. A liquidation of a company’s stock may also qualify for the QSBS treatment.
Transactions that involve a hedge may not qualify for the QSBS treatment unless the seller in the transaction held the QSBS for five years before the transaction took place.
PE and VC managers should review their current portfolios to determine whether any of their portfolio companies meet the QSB definition. They should also review current year sale transactions to determine if any current year gains might qualify for the Section 1202 exclusion. .
PE and VC managers should also make it a priority to determine if a portfolio company investment might qualify as a QSB during the due diligence process of making such an investment. It can be challenging to gather the appropriate documentation from company personnel to make a QSBS determination years after the initial investment was made.
For qualifying transactions, it is important to review the necessary footnote disclosures that will be reported on investors’ Schedule K-1s. PE and VC managers may also want to consider a broader Section 1202 discussion with their partner group to make partners aware of the potential Section 1202 benefits.
Consult with a Tax Advisor
A tax professional experienced with the opportunities under Section 1202 can help PE and VC investors determine their eligibility to use the QSBS tax incentive. For more information, please contact your local tax advisor.
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