Temporary Window to Exclude 100% of Capital Gains on Qualified Small Business Stock
The recently enacted Small Business Jobs and Credit Act of 2010 (the 2010 SBJCA) includes a number of important tax provisions relating to small business growth. One important provision amends Section 1202 of the Internal Revenue Code of 1986, as amended (the Code), to permit the exclusion of 100% of any gain realized on the sale of certain “qualified small business stock” (QSB Stock) acquired between September 28, 2010 and December 31, 2010. This Client Alert summarizes the existing tax rules and the changes to these rules made by the 2010 SBJCA. (Note: the requirements to qualify as QSB Stock are listed at the end of this Client Alert.)
Tax Law Changes
Before the passage of the 2010 SBJCA, a non-corporate taxpayer could exclude from gross income either 50% or 75%, depending on the date of issuance, of the gain arising upon the sale of QSB Stock held for more than five years. If the taxpayer was subject to the alternative minimum tax, however, the potential benefit of the 50% or 75% exclusion was recaptured as an AMT preference item, and therefore included as income regardless of when the stock was acquired. This resulted in tax rates that were very close to the regular long-term capital gains rate for non-QSB Stock, and thus, of little benefit to such taxpayers.
The 2010 SBJCA amended Section 1202 to provide for a temporary exclusion of 100% of gain realized on the sale of QSB Stock acquired on or after September 28, 2010 and before January 1, 2011. In addition, during this period, the excluded gain is not treated as a preference item for purposes of the AMT (although other limitations described below continue to apply). This change results in a potentially significant federal income tax benefit to non-corporate investors, essentially reducing to zero the capital gains tax on applicable QSB Stock.
As was the case before the 2010 SBJCA was enacted, gains realized on certain “offsetting short positions” are limited, and the amount of gain that can be excluded by any single taxpayer with respect to a particular issuer is generally limited to the greater of $10 million or 10 times the adjusted basis of the QSB Stock.
This change in tax law creates some planning opportunities for qualified small businesses,some of which are listed below. You should consult with your legal and tax advisors on the availability of any particular opportunity:
Stock Offerings: Any C-corporation that is planning to or considering issuing stock in the near future should think about whether to accelerate the offering to the 4th quarter of 2010. The company can promote a possible 0% tax rate to potential qualified investors, subject to the proper holding period.
Convertible Notes: Stock received upon the conversion of convertible debt is likely to be treated as QSB Stock by the IRS, so holders of convertible notes should consider converting before the end of 2010. Note, however, that the 5-year holding period begins on the note’s conversion date.
Key Hires and Compensatory Stock Grants: Because QSB Stock can be acquired in exchange for services, C corporations (especially start-ups) should consider issuing restricted stock to key employees before the end of 2010, especially if any restricted stock grants are already planned.
Stock Options: Stock options may be eligible to be treated as QSB Stock. If so, those with vested options could benefit from the tax law change to the extent they exercise these options before the end of 2010.
Consider Other Structures: An entity taxed as a partnership that is considering converting to a C-corporation should consider making the conversion before the end of 2010 and allow the former partners to receive QSB Stock (and the corresponding tax benefits). In addition, new business entities being formed before the end of 2010 should consider incorporating as C Corporations from the start to take advantage of possible 0% tax on long-term gains.
Requirements to Qualify as QSB Stock
- The issuer must be a C corporation established in the United States.
- The stock must be acquired in exchange for money, other QSB Stock, as compensation for services other than underwriting, or other non-stock property.
- The taxpayer must be an individual, trust, or estate (subject to exceptions for certain flow-through entities).
- The stock must be acquired at its original issuance, from the issuing C-corporation.
- The taxpayer must hold the stock for more than 5 years.
- The corporation cannot (directly or indirectly) redeem more than a de minimis number of shares held by the taxpayer, or certain related parties, within a four-year period beginning two years prior to the issuance of the QSB Stock.
- The corporation cannot have any “significant redemptions” of its stock from any party during the two-year period beginning one year prior to the QSB Stock’s issuance.
- The corporation must have aggregate gross assets that, at all times on or after August 10, 1993, through and immediately following the issuance of the QSB Stock, do not exceed $50 million. In calculating whether a corporation meets the aggregate gross asset test, subject to certain exceptions, cash is included at face value and other assets are valued at their adjusted tax bases.
- During substantially all of the taxpayer’s holding period, at least 80 percent (by value) of the corporation’s assets must be used in the active conduct of one or more qualified trades or businesses. A qualified trade or business includes any trade or business other than certain specifically excluded activities (for example, professional activities such as law or medicine, banking and finance, farming, mining, and the operation of hotels and restaurants). Special rules apply for purposes of determining whether the 80 percent requirement is satisfied, and limiting the allowed percentage of total assets for certain assets types (e.g., securities and real estate).
- The corporation must be an “eligible corporation” during substantially all of the taxpayer’s holding period, which excludes certain entities such as domestic international sales corporations, regulated investment companies, and real estate investment trusts and cooperatives.
- The issuer must agree to submit such reports to the IRS and shareholders as the IRS may require to carry out the purposes of Section 1202. (However, the IRS has yet to issue any such reporting requirements.)
- Special rules apply to stock received by a partner from a partnership, stock received in a reorganization pursuant to Code Section 368(a)(1)(F), or stock received solely through the conversion of other stock in the same corporation.
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