Qualified Small Business Stock Capital Gain Tax Exclusion Expanded
Bigger break for new start-ups.
October 28, 2010
On September 27, 2010, President Obama signed H.R. 5297 Small Business Jobs Act of 2010 (P.L. 111-240) into law, creating additional tax incentives for businesses and individuals – not just “small” businesses.
The purpose of the new law is to encourage entrepreneurs who may be sitting on the sidelines to stimulate the economy with new investment. The expansion of existing Internal Revenue Code (IRC or Code) Section 1202 offers a way to fully exclude future tax gains thereby materially increasing the after-tax return on the business. However, many of the provisions are not permanent and some have very short life-spans, some even expiring at the end of calendar 2010. Due to the complexities and limitations of these expanded provisions, pro-active planning at the time of establishing a new business and careful planning for the exit are critically important to securing the tax benefits under Code Section 1202.
The new Act includes:
This article will specifically discuss the 100-percent tax exclusion from capital gains of qualified small-business stock.
The Convoluted History of Code Section 1202
Under the general rule of Code §1202(a), an investor, other than a corporation, can exclude 50 percent of any gain from the sale or exchange of qualified small business stock held for more than five years. If the qualified small-business stock is issued by a corporation located in a federal Empowerment Zone and the sale or exchange occurs before December 31, 2014, the exclusion increases to 60 percent of the gain.
The taxable portion of the gain is taxed at a maximum rate of 28 percent (IRC Section 1(h)(7)). In addition originally, 42 percent of the excluded gain was an alternative minimum tax (AMT) preference item, which generally reduced the overall benefit of larger stock gains. For stock whose holding period began after December 31, 2000, 28 percent of the excluded gain is included in alternative minimum taxable income (AMTI). IRC Section 57(a)(7) before amendments.
The Jobs and Growth Tax Relief Reconciliation Act of 2003 (P.L. 108-27) amended Code §57(a)(7), resulting in only 7 percent of the excluded gain being included in AMTI. This was effective for dispositions on or after May 6, 2003. A sunset provision reverts back the law to its original language for taxable years beginning after December 31, 2010. P.L. 108-27, §303, as amended by P.L. 109-222, §102.
Under the American Recovery and Reinvestment Act of 2009 (ARRA), the 50-percent exclusion was increased to a 75 percent exclusion of gain from the sale or exchange of qualified small business stock acquired after February 17, 2009 and before January 1, 2011.
Under the new 2010 Act, the 75 percent exclusion has now been increased to a full 100-percent exclusion of gain from the sale or exchange of qualified small business stock acquired after September 27, 2010 and before January 1, 2011 — so time is limited in setting up a new eligible entity.
The five-year holding period continues to apply in order to obtain the full 100 percent exclusion.
The Fine Print
The gain, in any given tax year, from the sale or exchange of qualified business stock issued by a single issuer may not exceed the greater of:
Qualified Small Businesses and Qualified Small Business Stock
Qualified Small Businesses are limited to domestic C-corporations with aggregate gross assets under $50 million (before and after the issuance of the stock) (IRC Section 1202(d)).
Qualified small business stock is stock acquired by the taxpayer at its original issue (directly or through an underwriter) after August 10, 1993 in exchange for money, property other than stock (e.g. no stock via reorganization allowed) or compensation for services provided (e.g. IRC Section 83 transactions other than services performed as an underwriter of such stock) (IRC Section 1202(c)(1)). As mentioned above, the qualified small business stock must be held for more than five years before disposition (IRC Section 1202(b)(2)).
In addition, at least 80 percent of the value of the corporation’s assets must be used in the active conduct of one or more qualified trades or businesses during all of the taxpayer’s substantially holding period for such stock. Assets also used in start-up activities described in Code Section 195(c)(1)(A) and activities related to research and experimental expenditures under Code Sections 174 and 41(b)(4) within the first two years of the corporation’s existence will be treated as used in the active conduct of a qualified trade or business. Activities that do not constitute qualified trade or business are listed under Code §1202(e)(3) and generally exclude personal service businesses such as engineering, architectural, accounting and law firms. Banks, financial service firms as well as businesses involved in extracting natural resources are also excluded from the IRC Section 1202 benefits (IRC Section 1202(e)).
Impact on AMT — Important Relief
Before the new Act was signed, seven percent of the excluded gain was to be treated as an AMT preference item.
Under the new Act, the excluded gain from the sale or exchange of qualified small business stock that is acquired after September 27, 2010 and before January 1, 2011 that is held for more than five years, will not be considered an AMT preference item. Thus, eligible gain is excluded from both “regular” federal taxable income as well as AMTI.
State Tax Consequences
Since not all states conform to federal laws and regulations, each state may differ on their treatment of the gain from the sale or exchange of qualified small business stock. Certain states may not have adopted the original exclusion, certain states may not have adopted the percentage increases in the exclusion of gain and others may have adopted the exclusion but did not conform to the federal dates of enactment. Therefore, taxpayers and practitioners must also consider the state tax ramifications of formation and disposition.
Escaping Double Taxation
The new Act provides a small window of opportunity for qualified small businesses to operate as a corporation without the double taxation inherent in C-Corp disposition. Other means of escaping double taxation include forming an S-corporation or LLC or paying out the C-Corp earnings to the owners as deductible compensation or rent (to a reasonable extent).
Additional Things to Consider
The date of disposition of the qualified small business stock should be carefully considered as to meet the five-year holding requirement. Furthermore, the date of acquisition of the qualified small business stock and the initial capitalization should be carefully documented in order to properly account for the various changes to the exclusion percentage.
Qualified small businesses seeking to raise capital must act quickly in order to issue stock by the end of the year. Stock issued as compensation for services (IRC Section 83) rendered before September 27, 2010 does meet one of the qualifications for qualified small business stock set forth above.
According to paragraph 205 of Small Business Jobs Act of 2010: Law, Explanation & Analysis, it is important to note that the exclusion not only applies to the sale of qualified business stock, but also to other disposition transactions that are treated as sales or exchanges. Thus, liquidations under IRC §331, redemptions under Code Sections 302 and 303 (and possibly 304) and distributions under Code §301(c)(3) (after earnings and profits and basis have both been exhausted) all appear to be eligible for the exclusion under IRC §1202.
Unless there is another extension beyond December 31, 2010, the original 50 percent or 60 percent gain exclusion rules will again be in effect under Code Sections 1202(a)(1) and 1202(a)(2), as well as the AMT preference item of 28 percent or 42 percent of the excluded gain, depending on whether the holding period began after December 31, 2000.
Investing in qualified small businesses can be beneficial to both the individual investors and to the economy as a whole. Especially with the increased 100 percent exclusion of eligible gain, taxpayers may take advantage of these potentially significant tax savings and qualified small businesses may receive the support they need as they struggle to recover from the economic downturn.
Because of these benefits, Taxpayers planning to incorporate their business in 2011 should consider pushing to file necessary documents and issuing stock before the end of 2010.
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