If your “C” Corporation stock qualifies as Qualified Small Business Stock (“QSBS”), you may be eligible to eliminate paying tax on a portion or possibly all of your gain on the sale. This article will explain the general rules to determine if you might, in fact, own QSBS and if so, the amount of gain that you can exclude from federal tax.
In accordance with Internal Revenue Code section 1202, to meet the definition of QSBS, certain requirements must be met both at the time the stock is issued as well as during the time that the shareholder holds the stock. These requirements are set forth below.
QSBS stock must be issued by a domestic C corporation that is not a mutual fund, real estate investment trust, or certain other entities. In addition, the corporation’s aggregate gross assets cannot have exceeded $50 million at any time from inception to the date of the stock issuance, or immediately after such issuance. In general, aggregate gross assets include cash and the aggregate adjusted basis of property held by the corporation.
The shareholder must acquire the stock in an original issuance from the corporation in exchange for money, property, or as compensation for services provided to the corporation. Thus, a shareholder who acquires stock in a corporation via the purchase of an existing shareholder’s shares will not be treated as holding QSBS. Only non-corporate taxpayers are eligible for the gain exclusion. Thus, the investment in QSBS can be made either directly by an individual or indirectly through an eligible pass-through entity, including an S corporation, partnership, regulated investment company or common trust fund. There are additional considerations when stock is acquired as part of a tax-free reorganization.
To qualify as QSBS, the stock must be issued by a corporation that meets an active business requirement. This means that during substantially all of the time the taxpayer holds the stock, the corporation must be a C corporation, at least 80% of the value of the corporation’s assets must be used in the active conduct of one or more qualified businesses, and the corporation must be an “eligible corporation.”
Any assets held as part of the reasonably-required working capital needs of a qualified trade or business of the corporation, or held for investment and are reasonably expected to be used within two years to finance research and experimentation in a qualified trade or business, are treated as used in the active conduct of a qualified trade or business. If a corporation has been in existence for at least two years, then no more than 50% of the cash of the corporation qualify as used in the active conduct of a qualified trade or business under this rule. For purposes of the 80% test, a corporation may be treated as being engaged in an active trade or business even before the corporation has begun generating income.
A corporation shall not be treated as meeting the active business requirement for any period during which more than 10 percent of the total value of its assets consists of real property that is not used in the active conduct of a qualified trade or business. For purposes of the preceding sentence, the ownership of, dealing in, or renting of real property shall not be treated as the active conduct of a qualified trade or business.
A qualified trade or business excludes: (1) any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, etc.; (2) banking, insurance, financing, leasing, investing, or similar business; (3) farming (including the business of raising or harvesting trees); (4) the production or extraction of products subject to percentage depletion; and (5) a hotel, motel, restaurant, or similar business.
To be an “eligible corporation,” the corporation generally must be a domestic corporation that is not a DISC, a REIT, RIC, REMIC, or cooperative. If a corporation owns more than 50% of the stock of a subsidiary corporation, the parent corporation is treated as conducting its ratable share of the subsidiary’s business, making it more likely the parent corporation will satisfy the active business requirement.
Certain purchases by the corporation of its own stock can affect the eligibility of all stock issuances by the entity. For example, any stock acquired by the taxpayer will not be treated as QSBS if, at any time within 2 years of the issuance, either before or after, the issuer purchased (directly or indirectly) any of its stock from the taxpayer or from a person related to the taxpayer. Further, any stock issued by a corporation will not be treated as QSBS if at any time within 1 year of the issuance, either before or after, the issuer purchased from any shareholder stock with a value (as of the time of the respective purchases) exceeding 5 percent of the aggregate value of all of its stock as of the beginning of such 2-year period. A stock purchase is disregarded if the stock is acquired as a result of a termination of services for employees and director, the stock was acquired by the seller in connection with the performance of services as an employee or director, or the stock is purchased from the seller incident to the seller’s retirement or other bona fide termination of such services.
The taxpayer must hold the QSBS for more than five years. The holding period begins on the day after the date of issuance, whether or not the QSBS is received in a taxable or in a non-taxable transaction. Further, taxpayers can obtain a carryover or tacked holding period in certain circumstances, including special rules for contributions to and distributions from a partnership, stock option transactions, gift transfers and transfers at death. Additionally, the taxpayer and certain parties related to the taxpayer must not engage in certain hedging transactions during the taxpayer’s holding period.
If QSBS was acquired after September 27, 2010, then the taxpayer may be entitled to exclude 100% of the federal gain up to a certain limit. In addition, such gain is exempt from both the AMT and the net investment income tax. Note that section 1202 limits the exclusion to the greater of $10 million or 10 times the taxpayer’s adjusted basis in the stock. Also note, if QSBS was acquired on or before September 27, 2010, there is a partial exclusion. For acquisitions after February 18, 2009 through September 27, 2010 75%, of the gain can be excluded and for acquisitions after August 10, 1993 through February 17, 2009 the exclusion is 50%. There is no exclusion for stock acquired on or before August 10, 1993.
In summary, section 1202 can present a valuable tax savings opportunity for non-corporate taxpayers. The requirements can be onerous and there are many tax issues that are beyond the scope of this article. If you think you may be able to take advantage of these tax provisions, please contact Withum for further assistance.