A Very, Very Short Window of Opportunity for Investments In Qualified Small Business Stock
Gain from the sale of qualified small business stock purchased before the end of year and held for five years will be excluded from taxation and as a preference item for the alternative minimum tax.
November 11, 2010
To encourage new investment in small businesses, the Small Business Jobs Act of 2010 provides a temporary provision to exclude from taxation 100 percent of the gain from the sale of small business stock by an individual who has held the stock for five years and to exclude the gain as a preference item under the alternative tax. To qualify, the taxpayer must acquire the small business stock after the date of the enactment of the Act, September 27, 2010 and prior to January 1, 2011.
The exclusion of gain from the sale of stock of a qualified small business in various percentages has been in existence since 1993. The exclusion had initially been 50 percent of the gain, but had temporarily been raised to 75 percent for stock issued between February 17, 2009 and before January 1, 2011. The Small Business Jobs Act temporarily increased the exclusion percentage to 100 percent for qualified small business stock acquired after September 27, 2010 and before the end of 2010 and held for more than five years. The act also excludes the gain from treatment as an alternative minimum tax preference item. The 50 percent exclusion is scheduled to return for qualified small business stock acquired after December 31, 2010. All gain from the sale of qualified small business stock not excluded is subject to a capital gains tax of 28 percent and included as a preference item for the alternative minimum tax.
Eligible Taxpayers for Small Business Stock Gain Exclusion
The exclusion of gain from the sale of qualified small business stock is available to a taxpayer, other than a C corporation. Also, qualified small business stock gain received by a non-corporate taxpayer through a pass through entity, such as a partnership, S corporation or trust, is eligible for exclusion, as long as the entity owned the stock for more than five years and the non-corporate taxpayer owned continuously an interest in the entity from the date of acquisition of the stock to the date of disposition.
Qualified Small Business Stock
To qualify as qualified small business stock, the stock must have been acquired upon its original issuance from the issuing corporation, which, at the time, was a “qualified small business”, in exchange for cash or property or as compensation for services rendered to the issuing corporation. The issuing corporation must be a domestic C corporation that satisfies the active business requirements and is engaged in a qualified trade or business during substantially all of the time the stock is held by the taxpayer. At the time of issuance of the stock, the business must not have more than $50 million in assets, including the assets received for the stock being issued. However, during the term that the stock is held, the qualified small business may have in excess of $50 million in assets.
Active Business Requirement
Stock is qualified small business stock only if the corporation meets the active business requirement during substantially all of the time that the stock is held. A corporation meets the active business requirement if at least 80 percent of its assets by value are used in the active conduct of one or more qualified trade or business. A qualified trade or business is any trade or business other than:
The ownership of real estate not used in the qualified trade or business can automatically cause the corporation to fail the qualified trade or business test.
Working capital is considered used in a qualified trade or business, even if temporarily invested in assets unrelated to the business. For a business that has been in existence for two years or more, the business will be disqualified if it holds more than 50 percent of its assets as working capital.
Assets used in start up and research activities in connection with a “future qualified trade or business” will be deemed to be used in a qualified trade or business.
Transfers, Conversions and Exchanges of Qualified Small Business Stock
There are certain rules with respect to the transfer of qualified small business stock. If qualified small business stock is transferred by gift or at death, the donee or heir is considered to have stepped into the shoes of the donor or decedent and the stock retains its character as qualified small business stock in the hands of the donee or decedent.
The conversion of qualified stock by the issuing corporation into a new class of stock will not result in disqualification and the new stock will be treated as qualified. The holding period of the converted stock will be tacked onto the holding period of the new stock. A partner receiving a distribution of qualified small business stock from the partnership will step into the shoes of the partnership, as long as the partner could have excluded the gain allocated to the partner were the partnership to have sold rather than distributed the stock.
Stock received as stock dividends or in a tax free recapitalization or reorganization will qualify for the exclusion if received in reference to the already qualifying stock and if the issuing corporation is a qualified small business at the time of the exchange.
Stock received in the tax free reorganization from a corporation that is not a qualified small business will continue to be treated as qualified with respect to so much of the gain as would have been recognized if the exchange were taxable. For example, an investor subscribes for $1 million of qualified small business stock. Three years later the stock is acquired by a public corporation in a tax-free exchange for stock of the public corporation. At the time, the qualified stock was valued at $3 million. The gain of $2 million will qualify for the exclusion as long as the investor holds the new stock for the balance of the five year holding period. Consequently, tax-free exchanges under a recapitalization or reorganization will not result in a disqualification of the existing gain at the time.
Limitations on Exclusion
There is a limit on the amount of gain from the sale of qualified small business stock that is eligible for exclusion. The aggregate gain subject to exclusion is limited to the greater of $10 million or 10 times the basis in the stock disposed of during the year. Any amount of qualified small business stock gain that is not excluded is subject to a capital gain tax of 28 percent.
Rollover of Qualified Small Business Stock Gain
A seller of qualified small business stock that has been held for more than six months may elect not to recognize the gain to the extent of the cost of other qualified small business stock purchased during the 60 days following the sale. The gain that is not recognized is applied to reduce the basis of the purchased qualified small business stock and the holding period of the stock sold is tacked onto the stock purchased.
The potential tax benefits from the exclusion of gain on the sale of qualified small business stock are significant, but the myriad of requirements, restrictions and limitations pose a significant disincentive. These rules, when combined with the long five year holding period, prove to be a major impediment.
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Thomas R. Wechter, JD, LLM, is partner at Schiff Hardin LLP and concentrates his practice in the area of tax planning for individuals, corporations and partnerships and also handles matters involving tax controversies. Wechter has an LL.M. degree in Tax from New York University.