UPDATE: Due to the TCJA there are changes to IRS QBI deductions. Click here to learn how the new deductions work.
Do opportunities exist to reduce or defer tax when small business stock is sold? SC&H Group’s Tax Services team offers information below on two sections of the Internal Revenue Code that provide an opportunity for taxpayers to reduce or defer gains on qualified small business stock.
There are two sections of the Internal Revenue Code that provide an opportunity to reduce or defer your tax when small business stock is sold. Section 1202 permits a taxpayer to exclude a specified percentage of such gain, while §1045 permits a taxpayer to defer recognition of gain if the taxpayer reinvests in qualified small business stock within sixty days.
Definition of Qualified Small Business Stock (QSBS)
First, it is important to define “qualified small business stock” for the purposes of this discussion. “Qualified small business stock” means any stock in a domestic corporation that is originally issued after August 10, 1993 if: (1) the corporation is a “qualified small business” upon issuance of the stock; and (2) the stock is acquired by the taxpayer at its original issue in exchange for money, other property (not including stock), or as compensation for services provided to the corporation.
QSBS Opportunities Based on Section 1202
Section 1202 permits a taxpayer, other than a corporation, to exclude (in general):
- 50% of the gain realized on the sale of qualified small business stock if the taxpayer holds the stock for more than five years before the sale;
- 75% of the gain if it acquired the qualified small business stock after February 17, 2009 and before September 28, 2010 and held it for more than five years;
- 100% of the gain if it acquired the qualified small business stock after September 27, 2010 and before January 1, 2015, and held it for more than five years. The amount of gain which may be excluded in this manner is limited, on a “per issuer” basis, to the greater of $10 million or ten times the taxpayer’s basis in the stock that was sold during the year*.
(*Note – The $10 million exclusion is one-time only. A taxpayer cannot exclude $10 million in year 1 for selling part of the stock and then exclude an additional $10 million in year 2 for an additional sale of stock in the same QSBS.)
Generally, a portion of the gain excluded under §1202 must be added back as a preference for alternative minimum tax purposes. State income tax treatment varies; however, benefits here are often overlooked when structuring a transaction.
To prevent circumvention of the requirement that stock be “newly issued”, stock acquired by the taxpayer will not be treated as qualified small business stock if the corporation purchases any such stock from the shareholder or a related person within two years before or after issuance of the shares for which the exclusion is sought. Furthermore, §1202 treatment will not be available to a taxpayer if, within one year before or after issuance, the corporation redeems more than 5% of the aggregate value of all of its stock as of the beginning of such period (although redemptions incident to certain events, such as death, divorce, disability and incompetency, and certain de minimis redemptions are disregarded for these purposes).
A “qualified small business” is a domestic C corporation, the gross assets of which at all times from on or after August 10, 1993 through the issuance of the stock in question do not exceed $50 million (without regard to liabilities). These gross assets are valued at original cost instead of fair market value, with the exception of contributed property.
The corporation must conduct an “active business”, rather than simply be an investment company. An active business must be carried on for substantially the entire holding period of the taxpayer’s stock. This can apply for more than just the five-year period for a §1202 exclusion. In general, 80% of the assets must be used in the active business. Also, a corporation will fail the active business requirement if more than 10% of the value of its net assets consists of stock and securities of other corporations (not including that of a subsidiary). In addition, a corporation does not meet the active business requirement if more than 10% 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 these purposes, the ownership of, dealing in, or rental of real property is not considered the active conduct of a qualified trade or business.
Gain from the disposition of qualified small business stock by a partnership, S corporation, regulated investment company, or common trust fund that is taken into account by a partner, shareholder, or participant therein is eligible for the §1202 exclusion if all of the requirements of a qualified small business and qualified small business stock are met and if the taxpayer held its interest in the entity on the date the stock was acquired and at all times thereafter until the stock’s disposition. To prevent circumvention of the holding period requirements, the amount of gain excluded cannot exceed the amount determined by reference to the taxpayer’s pro-rata interest in the entity upon the acquisition of the stock.
Generally, if the stock represents an interest in a qualified business entity under the empowerment zone rules, as well as meets all the requirements to qualify for the general 50% exclusion, 60% exclusion applies. There are two exceptions to the 60% exclusion rate: DC enterprise zones do not qualify and the gain must be recognized before December 31, 2018.
It is important to also note that any §1202 gains which are subject to tax (i.e., any amount not excluded) is taxed under the old 28% capital gains. Essentially, if half of the gain is excluded under the 50% rules, the overall tax rate is actually 14%. A greater federal benefit is realized when there is 60%, 75%, and 100% exclusions of gains under §1202. As previously mentioned, state tax benefits may provide further incentives to use §1202 exclusions.
QSBS Opportunities Based on Section 1045
Section 1045 permits a taxpayer, other than a corporation, selling qualified small business stock to defer gain on such sale by rolling over the gain into a new investment in qualified small business stock. Rollover treatment under §1045 is available if: (1) the taxpayer has held the original stock for more than six months; and (2) the taxpayer makes a special election to claim §1045 treatment on the taxpayer’s federal income tax return for the year of sale.
Deferral of gain under §1045 is available only to the extent that the amount realized upon sale does not exceed: (1) the cost of any new qualified small business stock purchased during the 60-day period beginning on the date of such sale; reduced by (2) any portion of such cost already used to shelter gain under §1045 with other reinvestments.
The deferral under §1045 can be used first, with the §1202 exclusion then available for any remaining gain that is not deferred under §1045.
The application of these rules in any specific instance is complex and requires careful planning. Have you recently sold qualified small business stock, or are you planning to sell stock? Don’t overlook these possible tax benefits – contact SC&H Group’s Tax Services team here to discuss how these rules may apply to your specific situation.