Eligible Investors May Receive 100% Tax Exemption for Gain on Certain Stock Acquired Before Year-End
December 7, 2010
The Small Business Jobs and Credit Act of 2010 temporarily permits a total exclusion from federal income taxation of gain from the sale of certain qualified small business stock (“QSBS”). To take advantage of this tax benefit, the stock must be acquired from a qualifying issuing corporation after September 27 and on or before December 31, 2010, and the investor must then hold the stock for more than five years. The investor must be a non-corporate taxpayer and for any one investor, the maximum amount of gain eligible for the exclusion with respect to the stock of a single issuer is the greater of $10 million or 10 times the investor’s basis in the stock of the issuing corporation.
Unlike the existing QSBS rules (which generally provide for 50 or 75 percent exclusions of gain from qualifying sales of QSBS), the short-term total exclusion provides the additional benefit that the excluded amount also is not subject to the alternative minimum tax. As a result, under the temporary 100 percent exclusion, the effective federal income tax rate on qualifying capital gains generally will be zero.
Only non-corporate investors, including individuals, estates and trusts, qualify for the benefits of the QSBS gain exclusion rules. A non-corporate investor that owns an interest in a flow-through entity (such as an LLC, partnership or S corporation) also may be eligible for the exclusion with respect to their share of the gain from the sale of QSBS held by the flow-through entity, provided that certain special rules are satisfied.
Qualified Small Business Stock
Stock is QSBS only if the following requirements are met: (1) the investor must have acquired the stock at original issue from the corporation in exchange for money or property (other than stock) or as compensation for services to the corporation (other than as an underwriter of the stock); and (2) the issuer of the stock is a “qualified small business.”
Acquired at Original Issue The tax benefits of the QSBS exclusion are available to investors (including service providers and founders) that acquire stock (but not options, warrants, phantom stock rights or debt) from the issuing corporation. As previously described, the stock must be acquired from the corporation in exchange for money or property (other than stock) or as compensation for services (other than as an underwriter). For this purpose, converting debt into stock and the exercise of investor warrants or employee stock options are treated as the acquisition of stock at original issue.
Qualified Small Business Requirement
For stock to qualify as QSBS, the issuer of the stock generally must satisfy the following requirements:
- The issuer must be an eligible domestic C corporation. DISCs, RICs, REITs, REMICs, FASITs, cooperatives and certain other special types of corporations are not eligible corporations.
- The aggregate gross assets of the issuer must not have exceeded $50 million (as determined under special rules) at any time from inception up to the time immediately after the issuance of stock to the applicable investor.
- The corporation must submit any reports that the IRS requires. Currently, the IRS has not created any reporting requirements for QSBS issuers.
- The issuer must use at least 80 percent (by value) of its assets in the active conduct of one or more qualified trades or businesses during substantially all of the applicable investor’s holding period. It should be noted that:
- A number of types of businesses are expressly excluded from being “qualified trades or businesses.” For example, any trade or business involving the performance of services in the fields of health, law, engineering, consulting, financial services and certainmany other types of services business will not qualify. In addition, hotel and restaurant, oil and gas, banking or investment, farming and certain other types of businesses will not qualify.
- Research and start-up activities in connection with a future qualified trade or business generally may be treated as the active conduct of the qualified trade or business, regardless of whether these activities have generated any gross income.
- For purposes of the 80 percent test, in addition to assets clearly used in the active conduct of a qualified business, the following assets also may be counted as used in the active conduct of the business: (1) assets held for working capital needs; and (2) assets held for investment that are reasonably expected to be used within two years to finance research and experimentation in a qualified trade or business or to finance increases in the corporation’s working capital needs. If a corporation has been in existence for at least two years, however, no more than 50 percent of the assets of the corporation will qualify as used in an active trade or business by reason of the rules described in (1) and (2).
- There are limitations on the amount of portfolio stock and real estate that a corporation may hold and still be considered engaged in the active conduct of a qualified trade or business.
- An otherwise eligible corporation that is licensed to operate as a “specialized small business investment company” (or SSBIC) under section 301(d) of the Small Business Investment Act of 1958 (as in effect on May 13, 1993) is deemed to satisfy the active business requirements.
Certain redemptions by the issuing corporation of its stock within two years (or one year, in some cases) before or after the issuance of stock may disqualify the issued stock from QSBS status.
This summary is intended to provide an overview of some of the key requirements for the temporary 100 percent exclusion from federal income taxation of gain from the sale of certain QSBS. If you would like to determine whether an issuance of your company’s stock could qualify for this temporary exclusion, please contact your counsel or one of the attorneys listed above.