Changes to the Tax Law Have Encouraged the Use of the Section 1202 Small Business Stock Gain Exclusion
The U.S. has allowed small business stockholders to exclude profits from stock sales from their income since 1993. However, the exclusion under Section 1202 of the Tax Code has taken on greater importance after the 2017 Tax Cuts and Jobs Act (TCJA) encouraged small business owners to form as C corporations.
The TCJA cut the federal corporate income tax rate to a flat rate of 21%, making the corporate business structure more attractive because the income flowing to the individual members of a partnership may be taxed at up to 37%. The TCJA also made it more attractive for small business owners to organize as C-corporations by limiting the ability of individual taxpayers to claim federal deductions for local and state income, property, and sales taxes. C-corporations are still allowed to deduct their state and local tax payments fully.
Before the passage of the TCJA, small businesses tended to avoid organizing as C corporations because it subjected business profits to double-taxation since income is taxed at both the corporate and stockholder levels. C corporations were also subject to a maximum income tax rate of 35% before the TCJA cut it to the 21% flat rate.
To avoid double taxation, most business advisors recommended that small businesses organize as “pass-thru entities,” such as partnerships or S corporations. Pass-thru entities avoid double taxation because their income is only taxed when it is distributed to the individual owners.
What is the Exclusion for Small Business Stock Sales?
Section 1202 excludes any gain resulting from the sale or exchange of qualified small business (QSB) stock held for at least five years from taxpayer income. Section 1202 was added to the Tax Code in 1993 to provide an incentive for taxpayers to invest in small businesses.
However, the amount a taxpayer may exclude from income depends on when the QSB stock was initially issued. If the QSB stock was issued before February 2009, the exclusion is capped at 50%. The exclusion raises to 75% for QSB stock issued between February 18, 2009, and September 27, 2010. There is a 100% exclusion on the gain from QSB stock that was issued after September 27, 2010.
There are some limits on the gains that may be excluded from a single QSB stock. A taxpayer may only exclude gain that is the greater of:
- $10 million (which is reduced by the amount excluded from sales or exchanges of QSB stock from the same corporation in prior years); or
- 10 times the aggregate adjusted basis of the QSB stock disposed of by the taxpayer in that year. The basis is calculated from the original issue date.
A corporation issuing QSB stock that qualifies for the exception may have assets of up to $50 million when it is formed. That means under the 10X-basis limitation, the maximum gain eligible for the exclusion could reach a combined $500 million for the initial holders of the QSB stock in a C corporation with initial assets of $50 million.
Which Taxpayers May Claim the Exclusion?
To qualify for the QSB stock exclusion an individual must acquire stock in the C corporation when it was originally issued in exchange for money, non-stock property, or as compensation for services the individual provided the corporation.
QSB stock may also be held by a partnership or an S corporation (pass-thru entities). Partners or shareholders are allowed to exclude their share of any gain the entity recognized when it disposed of the QSB stock. However, the pass-thru entity must satisfy all of the requirements of an individual claiming the exclusion, including the five-year holding period.
The partner or shareholder is only allowed to exclude the gain from the sale of QSB stock if the partner or shareholder held an interest in the pass-thru entity on the date the entity acquired the stock. The partner or shareholder must also retain an interest in the entity the entire time it holds the QSB stock.
What is a qualified small business?
Section 1202 defines a qualified small business as a domestic C corporation that meets the three following requirements:
- Has aggregate gross assets, including those of any predecessor corporation, that are not more than $50 million at any time after August 1993 and before issuing its stock;
- Has aggregate gross assets that do not exceed $50 million immediately after the stock is issued, including funds that are received when the stock is issued; and
- Agrees to submit the required reports to the secretary of the U.S. Treasury and shareholders.
The Active Business Test
The C corporation must also satisfy the active business test to qualify for QSB stock treatment. An active business must meet the two following criteria:
- Use at least 80% of its assets to conduct a qualified business or trade; and
- Not be a current domestic international sales corporation, a former domestic international sales corporation, regulated investment company, cooperative, real estate investment trust, or real estate mortgage investment conduit.
For the purposes of the 80% test, the assets used to actively conduct the qualified trade or business include the following:
- Assets that are used in startup activities and research and development;
- Assets that are held for the corporation’s reasonable working capital needs;
- Assets held for investment that could reasonably be used within the next two years, limited to 50% of the corporation’s assets two years after the corporation was formed; and
- Computer software rights that lead to the production of certain royalties.
Under Section 1202, stock in the following types of business are not QSB stock:
- Any business in which the principal asset is the reputation or skill of one or more employees, including such fields as health, law, engineering, architecture, accounting, consulting, or financial services;
- Any businesses focusing primarily on banking, insurance, investing, or similar business;
- Any business that primarily operates a hotel, motel, restaurant, or similar business;
- Any farming business; or
- Any business involved in activities related to the production or extraction of oil or gas.
QSB Stock Transfers and Entity Conversions
Transferees may receive QSB stock in certain situations. For example, if a taxpayer is holding QSB stock through a partnership, distributing the stock from the partnership to a taxpayer in a non-recognized transaction allows the taxpayer to add the partnership’s QSB stock eligibility period to that of the individual taxpayer to meet the five-year holding requirement. Likewise, when a taxpayer gifts or bequeaths QSB stock, the recipient can add the taxpayer’s holding period to his or her own.
The holding periods for tax-deferred incorporations and reorganizations are treated in much the same way. The successor stock received in exchange for QSB stock will retain the character of the QSB stock and its holding period.
QSB Stock Rollovers
Taxpayers are allowed to roll over the gain on the sale or exchange of QSB stock into the QSB stock of another corporation under Section 1045 of the Tax Code. The replacement QSB stock must have a fair market value equal to or greater than that of the disposition of the original QSB stock. The taxpayer must hold the original QSB stock for more than six months prior to its sale or exchange and the rollover must take place within 60 days of the disposition of the original QSB stock.
For the purposes of calculating the five-year QSB stock holding period, the time the taxpayer held the original stock prior to disposition will count toward the holding period of the replacement QSB stock.
Categorised in: Startups
This post was written by Sean Allaband