For many years, taxpayers have overlooked the significant gain exclusion benefits of owning Qualified Small Business (QSB) stock. But do not despair. Now may be the optimal time to plan into these provisions – either by deciding to operate a new business as a taxable corporation (C corporation) or incorporating a business previously held in a pass-through solution. Below, we supply a road map of what benefits are available and who may qualify.
Over the past decade, economic and regulatory influences have been building to create the “perfect storm” for taxpayers to avail themselves of the QSB provisions:
- 2010 - Temporary expansion of the QSB incentive (increase in gain exclusion percentage to 100%);
- 2015 - 100% exclusion made permanent;
- 2017 - Tax Cuts and Jobs Act (TCJA) lowers the U.S. corporate rate to 21%;
- 2020 - Global pandemic depresses values and creates a potential for massive domestic infrastructure and supply chain investment.
Today, these factors amount to a structuring “mulligan” – A chance for small business owners, private equity, and venture capital investors to re-evaluate and re-structure to achieve QSB benefits they may have missed including gain exclusion, gain rollover, or ordinary loss treatment.
Gain Exclusion (IRC Section 1202)
Individuals, trusts, and other noncorporate taxpayers may exclude some or all of the eligible gain from the sale of QSB stock, contingent upon the date acquired (up to 100% if acquired after September 27, 2010).
Eligible gain includes gain from QSB shares the taxpayer held for more than five years. The cumulative amount of eligible gain is generally the greater of $10 million or ten times the taxpayer’s original basis in the QSB shares per issuer.
For example, if an individual currently owns a business valued at $50 million in pass through solution, that individual may incorporate the business into a C corporation in a non-recognition transaction today (achieving basis equal to the value for Section 1202 purposes), sell the stock five years from now, and shield up to $500 million of gain (ten times basis of $50 million) from both individual Federal income tax and net investment tax. State benefits may also be available based on the individual’s profile as many states conform to the Federal QSB benefits. However, a review is recommended since certain states (e.g. California, New Jersey, Pennsylvania) limit the exclusion or decouple from the Federal provisions.
When significant business appreciation is expected (e.g. startups), this value proposition (up to $500 million of gain exclusion) often outweighs the negatives (e.g. double tax on distributions, potential rate increases, discounted exit value for lack of buyer step-up). If structured properly in conjunction with certain estate tax planning, the gain exclusion may increase even further (e.g. by taking advantage of the per issuer limitation). Scenario analysis of QSB benefits (or identification of existing QSB benefits) is worthwhile for any noncorporate taxpayers with stock fitting the below profile.
Who May Qualify?
Shares of a corporation should qualify as QSB stock if:
- The issuer is a U.S. C corporation,
- The taxpayer acquired the shares at the original issuance directly from the corporation,
- The taxpayer acquired the shares in exchange for money, property (other than shares of corporate stock), or services provided to the corporation,
- The corporation has had aggregate gross assets of $50 million or less at all times since formation until immediately after the issuance to the taxpayer,
- 80% of the assets of the corporation (by value) are used in an active trade or business (defined below)(including the activities of subsidiaries), and
- The corporation does not hold greater than de minimis amounts of non-subsidiary stock or real estate.
Active Trade or Business
For purposes of the 80% test, an active trade or business is any business (U.S. or foreign) except the following:
- Any other trade or business where the principal asset is the reputation or skill of one or more of the employees (e.g. professional services, performing arts, athletics),
- Financial businesses (such as banking, insurance, leasing, investing, and brokerage services),
- Real estate businesses (such as owning, dealing in, renting),
- Farming and mining businesses, and
- Operating a hotel, restaurant, or similar business.
Gain Rollover (IRC Section 1045)
A further tax benefit of owning QSB stock is that non-corporate taxpayers can elect to roll over the gain from the sale. The rollover provisions only apply if the taxpayer has owned the small business stock for more than six months and the gain would otherwise have been eligible for exclusion under the QSB regime.
After the sale of stock at a gain, the taxpayer can reduce the taxable gain by reinvesting proceeds in QSB stock in a different corporation within sixty days of the sale. This rollover provision is ideal for taxpayers that have held QSB stock for more than six months but five years or less.
Ordinary Loss (IRC Section 1244)
Individuals are entitled to treat the loss, subject to limitations, from the sale or exchange of QSB stock as an ordinary loss if the loss would otherwise be treated as a capital loss. The amount of the loss that is eligible for ordinary character treatment is limited to $50,000 (or $100,000 in the case of taxpayers filing a joint return) per taxable year.
Ordinary loss treatment is generally available if:
- The taxpayer is the original purchaser of common stock issued by a domestic corporation;
- The consideration for the stock was cash or property (other than stock or securities);
- The aggregate amount of money and property received by the corporation for equity (including capital contributions) does not exceed $1 million; and
- The corporation derived more than 50% of its aggregate gross receipts from active sources (e.g. sources other than royalties, rents, dividends, interest, etc.) during the five most recent taxable years. (The source of income requirement does not apply if the corporation has an aggregate net loss during the applicable five taxable years.)
It should be noted that there are some differences between the requirements for QSB stock treatment under Section 1244 (ordinary loss) and the requirements under Sections 1202 (exclusion) and 1045 (rollover). It is possible that stock can qualify for one provision and not the other.
A&M Taxand Says
The tax benefits of QSB stock will come as a surprise to many taxpayers as the benefits have never been highly publicized. The possibility of avoiding (or deferring) the gain on the sale of corporate stock should be considered in deciding whether to operate a business as a corporation or as a pass-through. The current economic environment gives taxpayers an opportunity to re-evaluate their structures and make adjustments to avail of the substantial QSB benefits. A&M Taxand is helping business owners and investors qualify by navigating the complex rules, modeling their impact, and preparing supporting documentation. Reach out to discuss specific applicability and savings potential.