Qualifying C corporations have long offered tax benefits to their investors under Section 1202 of the Internal Revenue Code, but fluctuations in the benefit and the capital gains tax have limited its use. Tax reform under the law commonly known as the Tax Cuts and Jobs Act (TCJA) may make the Qualified Small Business Stock (QSBS) Exemption in Section 1202 benefit more widespread and appealing for small businesses. To take advantage of the QSBS Exemption, both businesses and their investors need to be aware of how it works, its potential limitations, and the planning opportunities available.
What Is the Qualified Small Business Stock Gain Exclusion?
Nearly 30 years ago, Congress passed the Revenue Reconciliation Act of 1993, which among other things, led to the creation of Section 1202. Under Section 1202, a domestic C corporation can issue QSBS if certain conditions are met. Qualifying investors can exclude the gain from their investment in QSBS if the stock is held for at least five years.
The QSBS Exemption is designed to incentivize investments in small businesses, so the C corporation issuing the stock must meet the definition of a Qualified Small Business. Its gross assets must not exceed $50 million between Aug. 9, 1993 (the effective date of the Revenue Reconciliation Act of 1993) and the issuance of the stock. Immediately after the date of issuance, the aggregate gross assets of the corporation—including the consideration received for the issuance of the stock—must not exceed $50 million. Once a C corporation has gross assets exceeding $50 million, it is permanently prohibited from utilizing the QSBS Exemption.
C corporations must also have at least 80 percent of its assets used for a qualifying trade or business. A number of business types are excluded from the benefit, including:
- Trades or businesses involving professional services where the service relies on the skill of its employees, including health, law, engineering, accounting, consulting, financial services
- Banking, insurance, financing or investing
- Most farming businesses
- Oil and gas extraction
- Hospitality, including hotel, motel, restaurants or similar businesses
The C corporation must remain a C corporation for substantially all of the stockholder’s holding period.
Which Types of Investors Benefit from the QSBS?
Investors also must meet certain requirements in order to take advantage of the capital gains exclusion. The investor cannot be structured as a C corporation. It also must acquire the QSBS directly from the Qualified Small Business (original issuance). The original issuance requirement includes:
- Exercising stock options or warrants or through a conversion of convertible debt
- Stock options acquired as a gift or estate benefit
- Stock options acquired as a distribution from a partnership under certain parameters
How Have the Benefits under Section 1202 Evolved?
Long-term capital gains rates and the percentage of gain exclusion available under Section 1202 have changed since the passage of the Revenue Reconciliation Act of 1993. These fluctuations, which have at times made the QSBS Exemption less attractive for investors, may be among the culprits for why the benefit has not been heavily used or well-understood.
In 1993, long-term capital gains were taxed at the same rates as ordinary income. The top rate was 28 percent. Section 1202 permitted qualifying investors to exclude up to 50 percent of their long-term capital gains at the end of their 5-year-holding period. The earliest the 50 percent exclusion applied was for gains after Aug. 10, 1998. Under the initial benefit, the effective tax rate for QSB capital gains was 14 percent.
Before 1998 came around, however, the long-term capital gains was reduced to 20 percent, and a provision was added to Section 1202 that made the 50 percent of capital gains not subject to the exclusion taxable at a 28 percent rate. The effective tax rate on QSBS was still 14 percent, but the lower regular capital gains tax and the alternative minimum tax adjustment for QSB gain exclusion made the QSB option less appealing for investors. In 2003, the capital gains tax was reduced again to 15 percent, and at that point, the QSBS Exemption was pretty much useless.
Several years later, Congress tried to reenergize the Section 1202 benefit by bumping up the percentage of QSBS gains that could be excluded to 75 percent in 2009 and then 100 percent in 2010. Additionally, with the 100 percent exclusion, there is no more alternative minimum tax adjustment. The full QSBS exclusion became a permanent tax benefit under the Protecting Americans from Tax Hikes Act.
The 100 percent permanent exclusion, and the TCJA changes that could potentially lead to more C corporation entity structures may bring new life to the QSBS Exemption.
Before rushing full throttle into qualifying C corporation investments, investors may want to evaluate some of the nuances in Section 1202 that could potentially limit them from receiving the full QSBS benefit.
Section 1202 comes with specific rules for redemptions. A Qualified Small Business that purchases more than a de minimis amount of its own stock and the total value of this stock exceeds 5 percent of all the company’s stock would not be eligible for the QSBS Exemption.
There are certain exceptions to the redemptions rule, including cases where the company automatically buys back stock from a departing employee. A liquidation of a company’s stock may also qualify for the QSBS treatment.
Contributing to Partnership Rule
Investors can receive QSBS from a partnership that has an investment in a Qualified Small Business when the following conditions are met:
- The partnership was the original recipient of the stock,
- The partner receiving the QSB stock has been a partner since the date the partnership acquired the QSBS and is a partner through the distribution date, and
- The partner’s share of the QSB stock interest cannot exceed the partner’s share in the partnership.
Transactions that involve a hedge may not qualify for the QSBS treatment unless the seller in the transaction held the QSBS for five years before the transaction took place.
Traditionally, pass-through entities have been the entity structure of choice for small businesses and start-ups. The new tax law changes that logic up by reducing the corporate tax rate to 21 percent. Companies may want to consider the C corporation structure and whether the benefits under Section 1202 will apply to them.
Small businesses or investors that do not qualify for the QSBS exemption may still have some planning options available to them to limit the capital gains tax consequences on their stock. Section 1045 provides rollover opportunities for investors to defer the gain on qualified small business stock that is held for at least six months.
Consult with a Tax Advisor
A tax professional experienced with the opportunities under Section 1202 can help both businesses and their investors determine their eligibility to use the Qualified Small Business Stock Tax exemption.
For more information, please contact us.
Joanna Powell, CPA is a Managing Director in the Tax Group. She can be reached at 617.761.0583 or email@example.com.