Tax Incentive Relating to the Sale of Qualified Small Business Stock

If you are fortunate enough to own and then sell stock that qualifies as Qualified Small Business Stock (“QSBS”), then a portion or all of the gain (up to 100% of the gain) may qualify for exclusion from federal income tax. For stock to qualify as QSBS, various requirements must be met, which are summarized in this article.

For stock to qualify as QSBS it must satisfy the requirements as outlined in Internal Revenue Code (“IRC”) Sec. 1202. IRC Sec. 1202 provides that eligible shareholders can exclude all or a portion of gain from the sale or exchange of Qualified Small Business Stock (“QSBS”) if the shareholder acquired the stock at its original issuance directly from the corporation in exchange for cash, other property, or as compensation for services provided to such corporation, and held the stock for more than five years.?For Sec. 1202 purposes, “eligible shareholders” are non-corporate shareholders such as individuals, trusts, and estates.

Sec. 1202 provides tiered exclusion amounts depending on the stock’s issuance date. For example, one hundred percent (100%) gain exclusion is available for QSBS issued after September 27, 2010, less of a percentage exclusion if the stock was acquired prior to the date.?The potential tax savings generated through application of Sec. 1202 are substantial as excludable gain is the greater of $10 million or ten times the individual taxpayer’s total adjusted basis in the QSBS at the time of issuance.??

In addition to the shareholder requirements, the stock issuing corporation must meet certain criteria before its shareholders are eligible for Section 1202 gain exclusion. In particular, the issuing corporation must be a qualified small business (“QSB”) and must satisfy the “active business requirement” (“ABR”) rules. A QSB is any domestic C corporation whose “aggregate gross assets” do not exceed $50 million before and immediately after a stock issuance.?For Sec. 1202 purposes, aggregate gross assets are “the amount of cash and aggregate adjusted bases of other property held by the corporation.” ?And adjusted basis in this case is fair market value.

The ABR is satisfied if at least 80 percent (by value) of the issuing corporation’s assets are used in the active conduct of a qualified trade or businesses (“QTOB”) for “substantially all” the taxpayer’s stock holding period.?Thus, most of the company’s assets need to be used in an active business (as opposed to an inactive or passive business) and the business must be of a specific type.

The IRC provides no clear definition of what constitutes a QTOB, rather the IRC provides businesses that are not QTOB. For example, 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, and brokerage services is not a QTOB, as well as any trade or business where the principal asset is the reputation or skill of one or more of its employees. Although limited information exists to clearly determine whether a business is a QTOB, taxpayers can infer what likely qualifies as a QTOB based on guidance provided by Tax Court cases, memos, various private letter rulings (“PLRs”), and reference to other IRC sections.?

Substantially all is another undefined term, but other Code sections seem to suggest it means at least 80 percent. While Section 1202 does not define “substantially all” directly it does address the definition of the active business requirement, which provides that at least 80 percent of the assets of such corporation are used by the corporation in the active conduct of one or more qualified trades or businesses. Thus, while the meaning of “substantially all” is unclear, taxpayers can likely apply, by analogy and inference, other Code sections and the ABR definition to arrive at a meaning of at least 80 percent of the individual’s holding period.

The preceding discussion contains an overview of pertinent Sec. 1202 qualifying factors as additional rules, nuances, and complexities must be considered before determining whether gain exclusion is possible. Previous stock redemptions, reorganizations, and working capital requirements can potentially “taint” Sec. 1202 qualification and thus negate tax benefits. It is recommended that a thorough analysis of a corporation’s underlying stock activity be considered with your tax advisor before claiming Sec. 1202 as a potential tax savings maneuver. If you have any questions about current or future corporate stock transactions, stock sales, or exit plans, please contact us to discuss application of Sec. 1202 to your specific situation.