I receive at least 5 calls per year with some variation of this question. The callers are asking about the exclusion for capital gain on the sale of qualified small business stock (QSBS). By the time they reach me, the callers have already spoken with their local tax advisors and/or looked on the internet, and they know there is a 5-year holding period in order to qualify for the QSBS exclusion in section 1202. But opportunity knocked and they sold their stock before hitting the 5-year mark, and they want to know definitively if there is anything they can do now to eliminate or minimize the tax bill, which is often in the millions of dollars.
The short answer is yes – there is something they can do if they act quickly, but it’s not easy. The solutions involve taking risk in another ongoing venture or making a genuine effort to start a new business. Neither of these options is risk-free and both require substantial due diligence before taking the plunge.
As I discuss these strategies with the callers and begin to assess their willingness to engage in them, I explain that my experience has been that one’s willingness to entertain them usually is inversely related to the amount of time needed to reach the 5-year mark. Callers with more than one year to go are almost never willing to do them, but those with a few months left are all ears (at least until they learn what is required to pass muster with the IRS).
Section 1202 generally provides for the full or partial exclusion of capital gain realized on the sale of QSBS. If the requirements are met, then taxpayers can exclude from gross income capital gain in an amount equal to the greater of (i) $10 million, or (ii) an annual exclusion of 10 times their basis in the stock sold (for an exclusion amount up to $500 million). Both limitations apply on a per-issuer and per-taxpayer basis, and while the rules limit the exclusion to the greater of the two rules, in practice, the $10 million rule is most often the limiting factor in start-up ventures.
The exact exclusion percentage depends on the date when the taxpayer acquired the QSBS from the issuer, rather than the date on which the stock is sold. The percentages range from 50% to 100%, with the latter applicable to QSBS acquired after September 27, 2010.
The first strategy is to purchase replacement stock within 60 days of the sale of the original stock. There are many requirements to a successful qualified rollover under section 1045, but if done right, the taxpayer can (i) defer gain on the sale of the original stock until the replacement stock is sold and (ii) add the holding period of the original stock to the holding period of the replacement stock. This tacking of the holding period enables the taxpayer to take advantage of the QSBS exclusion on the entire gain when the replacement stock is sold after the 5-year holding period is met on a combined basis.
For example, let’s assume Ben sells QSBS after owning it for 4 years and 6 months. One month later he uses the proceeds from the stock sale to acquire replacement stock in a qualified small business. Assuming Ben meets the rules for a qualified rollover, he can take advantage of the QSBS exclusion on the entire gain (i.e., gain that accrued on the original stock and gain that accrued on the replacement stock) if he sells the replacement stock 6 months and a day after acquiring it because at that point he would have met the 5-year holding period.
You’re probably thinking that 60 days is not a lot of time to identify a replacement business in which to invest, much less conduct due diligence to determine if it is a worthy investment. And you would be right, it is not a lot of time which is why very few people purchase replacement stock in a qualified rollover under section 1045. Another potential problem is that taxpayers will have to be able to sell their stock in the replacement company in order to recognize the QSBS exclusion down the road. This can be hard because buyers generally prefer to buy assets, rather than stock, because they want to avoid any hidden liabilities in the entity. The larger the business gets, however, the more likely a buyer would consider a stock purchase instead of an asset purchase. My unscientific assessment is that buyers are more willing to acquire stock instead of assets when the business is worth at least $30 million to $50 million.
Starting a New Businesses
The second strategy is a type of qualified rollover that involves forming a new C corporation (or more than one C corporation to stack the exclusion) for the purpose of operating a new qualified trade or business, either one that is newly created or one that is acquired from a third party. This overcomes the problem of finding replacement stock within 60 days, but it does require the taxpayer to act within 60 days to set up a corporation, issue stock, and begin putting the invested funds to work creating a business plan and executing it.
Taxpayers can begin work in the new entity by engaging in start-up and R&D activities as long as such activities are intended to lead to the conduct of an active business. And the amount of money invested should be reasonable in relation to the needs of the business. For example, it would not make sense to invest $400,000 into a business whose business plan calls for at least $5 million to get off the ground. Similarly, it would not be reasonable to invest $5 million into a business that requires only $400,000 to operate.
The key here is reasonableness and what one would feel comfortable explaining to an IRS agent if he/she were audited. The IRS agent will be looking to ensure there is economic substance to the formation and operation of the business, and that the taxpayer did not just park funds in a C corporation to ride out the 5-year holding period.
The exit plan for this strategy is either to sell the stock of the entity to a third party, which can be hard as explained above, or to liquidate the entity in a taxable transaction. If the business is unsuccessful and the liquidation route is taken after the 5-year holding period is met, then the IRS likely will take a hard look at the taxpayer’s business plan, the taxpayer’s activities undertaken to implement the plan, the reason for the termination of the business, and the amount of time between the date the taxpayer met the 5-year holding period and the date of the liquidation. The IRS will be looking for economic substance and whether the taxpayer made a genuine effort to start a qualified trade or business. The taxpayer’s ability to document the facts will be important.
The rules governing qualified rollovers are complex and the strategies discussed in this article should be undertaken only with advice from a qualified tax advisor. The cost of an advisor will be small relative to the stakes involved and this is not the time to be penny-wise and pound-foolish.