Legislation signed by President Obama on December 18, 2015, makes permanent a U.S. federal income tax exclusion from gross income of 100 percent of the gain recognized by non-corporate taxpayers on the sale or exchange of certain "qualified small business stock" (QSBS). The 100 percent gain exclusion applies to QSBS acquired after September 27, 2010, and held for more than five years. Entrepreneurs and investors who have formed or made investments in corporations that are qualified small businesses, or those who are considering doing so, should be aware of the potential advantageous tax treatment of investing in QSBS and of potentially delaying a taxable sale or exchange of QSBS until the five-year holding period has been satisfied.
Prior to the enactment of the Consolidated Appropriations Act of 2016 (CAA), Section 1202 of the Internal Revenue Code of 1986, as amended (the Code), provided a U.S. federal income tax exclusion for non-corporate taxpayers of 50 percent of any gain from the sale or exchange of QSBS acquired after August 10, 1993, and held for more than five years. The exclusion was increased to 75 percent for QSBS acquired after February 17, 2009, and to 100 percent for QSBS acquired after September 27, 2010, and on or before December 31, 2014, but, under prior law, would have reverted to 50 percent for QSBS acquired after December 31, 2014. The amount of gain permitted to be excluded by a taxpayer from the sale of QSBS of a single corporation generally is limited, regardless of the exclusion percentage, to the greater of $10 million or 10 times the taxpayer's adjusted basis in the QSBS (the QSBS gain limitation). For the sale or exchange of QSBS acquired during the 50 percent and 75 percent gain exclusion periods, a portion of the excluded gain was treated as an item of tax preference for U.S. federal alternative minimum tax purposes. Notably, however, gain eligible for 100 percent gain exclusion was also eligible for exemption from alternative minimum tax, which effectively eliminated U.S. federal income tax on such gain, subject to the QSBS gain limitation.
The CAA permanently extends the 100 percent gain exclusion and the alternative minimum tax exemption, retroactive to January 1, 2015. Therefore, U.S. federal income tax (including alternative minimum tax) on gain from the sale of QSBS acquired after September 27, 2010, and held for more than five years is effectively eliminated, subject to the QSBS gain limitation.
QSBS Background
Stock of a small business generally qualifies as QSBS if the stock meets certain requirements, including: (i) the small business is a domestic C corporation; (ii) the taxpayer acquired the stock at its original issue in exchange for money or other property (not including stock) or as compensation for services; (iii) during substantially all of the taxpayer's holding period of the stock, the small business is engaged in a qualified trade or business and uses 80 percent (by value) of its assets in the active conduct of one or more qualified trades or businesses (as defined below); (iv) the aggregate tax basis of the small business's assets from inception to the date the stock is issued (including proceeds received in exchange for the stock) is $50,000,000 or less; and (v) with certain de minimis exceptions, the small business has not made any repurchases of stock from any of its shareholders within the two-year period starting one year prior to the date the stock was issued or from the taxpayer claiming the QSBS gain exclusion or related parties within the four-year period starting two years prior to the date the stock was issued.
A "qualified trade or business" is defined as any trade or business other than: (i) any trade or business involving the performance of services, such as accounting, engineering, or consulting, or any other trade or business where the principal asset is the reputation or skill of one or more of its employees; (ii) any banking or financial business; (iii) any farming business; (iv) any mining or oil or gas business; and (v) any business of operating a hotel, motel, restaurant, or similar business.
As noted above, under the QSBS gain limitation, the amount of gain a taxpayer can exclude from the sale of QSBS of a single corporation is generally limited, regardless of the exclusion percentage, to the greater of $10 million or 10 times the taxpayer's adjusted basis in the QSBS.
In addition to the exclusions described above, under Section 1045 of the Code, an electing non-corporate taxpayer who (i) holds QSBS for more than six months (the original QSBS); (ii) sells the original QSBS in an otherwise taxable transaction; and (iii) during the 60-day period beginning on the date of such sale, purchases new QSBS (replacement QSBS) generally will recognize gain on its original QSBS only to the extent that the proceeds from such sale exceed the amount invested in the replacement QSBS (QSBS gain rollover). QSBS gain rollover would be a benefit with respect to QSBS acquired on or before September 27, 2010 (but after August 10, 1993), or to which the QSBS gain limitation applies. Further, if the QSBS was acquired after September 27, 2010, but the required holding period has not been met at the time of a sale or other disposition of such QSBS, an investor should consider whether QSBS gain rollover may be advisable to preserve the potential for the 100 percent gain exclusion if the five-year holding period is achieved (taking into account permitted tacking under Sections 1045 and 1223(13) of the Code).
