Permanent Full Exclusion of Gains from Qualified Small Business Stock

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“Founders and venture capital investors may qualify to exclude 100% of the gain from the sale of the stock in their startup company”

The recently enacted 2015 PATH Act included a number of tax provisions beneficial to startup companies.  Among the new legislation is a permanent extension to exclude 100% of gains from the sale of certain qualified small business stock (“QSBS”) acquired after September 27, 2010.  Prior to this legislation, the 100% exclusion was originally set revert back to a 50% exclusion for stock purchased after January 1, 2015.

The new legislation also makes permanent the exception from the alternative minimum tax (“AMT”) for QSBS gains.  Previously, taxpayers were required to include 7% of the excluded gain for AMT purposes.

Shareholders of startup companies may overlook this tax break intended to benefit them if they do not understand the numerous requirements to qualify for the exclusion.

What is QSBS and who qualifies for the exclusion?

The exclusion applies to taxpayers other than corporations that are shareholders of qualified small business stock and have held the stock for more than 5 years.  “Qualified small business stock” means stock in a domestic C Corporation which is originally issued after August 10, 1993, and meets all of the following requirements:

  1. The taxpayer must have acquired the stock at its original issue, meaning it cannot be acquired on the secondary market.
  2. The stock is acquired in exchange for money or other property or as pay for services. “Other property” generally does not include stock.
  3. The aggregate assets of the corporation are $50 million or less at all times after August 10, 1993, and before the stock was issued, and immediately after the stock was issued.
  4. During substantially the entire time the taxpayer held the stock, the corporation was a C corporation and at least 80% of the value of its assets was used in the active conduct of a “qualified business.”

Shareholders must be aware that certain businesses are ineligible from the QSBS exclusion.  These ineligible businesses generally include, but are not limited to, service businesses in the areas of health, finance, athletics and professional services such as law or accounting.  Also ineligible are banking, investing, and insurance companies, hospitality and travel businesses like hotels and restaurants, farming businesses, and businesses that claim depletion on the use of natural resources.

How is the exclusion claimed?

The QSBS exclusion is claimed on your federal income tax return in the year in which you sell qualified small business stock.  Gains recognized by “pass-thru entities” may be excluded by the entity’s partners, members, or shareholders.

In the year of the sale, the exclusion may not exceed the greater of $10 million or 10 times the original basis of the stock of the corporation sold during the tax year.  The $10 million must be reduced by QSBS gains from sales of the same corporation’s stock in prior years.

Founders of startup companies and qualifying venture capital investors who think they may qualify for the QSBS exclusion should be sure to take certain measures to document purchases of small business stock.  Shareholders should maintain records indicating when the stock was purchased and for how much, and also have the company certify it is a qualified small business at the time of purchase.  And remember, the stock must be held for at least 5 years before being sold.

As with most other provisions of Tax Code, there are a number of exceptions, limitations, and exclusions to these rules.  Please feel free to contact a member of our technology team if you have any questions or think you might be eligible to take advantage of this terrific tax savings opportunity.

Ryan Babiak, CPA Ryan Babiak, CPA
973-898-9494
rbabiak@withum.com

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To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

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