The Exclusion for Qualified Small Business Stock is in Play

On September 13, 2021, the House Ways and Means Committee released 881 pages of legislative text laying out its budget reconciliation proposals. It also issued an 18-page section-by-section summary of the proposals.

These proposals will be marked up in committee and are not set in stone, but if enacted in their present form they would raise more than $2 trillion in revenue over 10 years, according to a report issued by the Joint Committee on Taxation.

Our focus here is on the proposal to modify the rules relating to qualified small business stock (QSBS).

QSBS Generally

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 of these 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 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.

  • For QSBS acquired after August 10, 1993, and before February 18, 2009, the exclusion percentage is 50% of the amount of realized gain.
  • For QSBS acquired after February 17, 2009, and before September 28, 2010, the exclusion percentage is 75% of the amount of realized gain.
  • For QSBS acquired after September 27, 2010, the exclusion percentage is 100% of the amount of realized gain.

House Proposal

The proposal regarding QSBS, outlined in section 138150 of the legislative text, would raise $5.718 billion over 10 years. It would deny the 75% and 100% exclusion percentages to taxpayers whose adjusted gross income (AGI) equals or exceeds $400,000, but it would not deny §1202 benefits entirely. It would allow such taxpayers to take advantage of the 50% exclusion for QSBS.

The AGI limit would be determined without regard to §1202, meaning that if QSBS is sold for $500,000, then that income is counted for purposes of the $400,000 AGI limit even though such income could be excluded from gross income under §1202. Also, the AGI limit would not apply to trust or estates, so they could never take advantage of the 75% and 100% exclusion percentages.

The proposal would be retroactive to sales or exchanges occurring on or after September 13, 2021, subject to a binding contract exception. Under that exception, the proposal would not apply to any sale or exchange that is made under a written binding contract that was in effect on September 12, 2021 (and not modified in any material respect thereafter).

If you are in the process of selling QSBS under circumstances where you could be impacted by this proposal, you should reach out to your tax advisor before taking any further action,especially if you are thinking of modifying a written binding contract that was in effect before September 13, 2021. It is important to understand what can be done and what should not be done if you want to preserve the 75% or 100% exclusion rates under this proposal, assuming it is enacted in its present form.

Even if the 75% and 100% exclusion percentages do not apply, other planning considerations may still apply, such as stacking and packing.

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Contact Withum’s team of professionals if you have any questions or concerns.