Understanding the qualified small business stock gain exclusion

Section 1202 provides investors an opportunity to exclude some or all of the gain realized from the sale of qualified small business (QSB) stock held for more than five years. The gain exclusion is available provided all requirements are met, but is also subject to limitations. As originally enacted, the gain exclusion was limited to 50% of gain, but it was increased to 75% (for QSB stock acquired after Feb. 17, 2009, and before Sept. 28, 2010), and then to 100% (for QSB stock acquired after Sept. 27, 2010).¹As further discussed below, this gain exclusion is generally limited to the greater of $10 million or 10 times the aggregate adjusted bases of the QSB stock that an investor sold during the taxable year.

Prior to establishment of the 100% exclusion, QSB status did not provide most investors with as significant of a benefit, as the gain not excluded was taxed at a rate significantly higher than the existing capital gain rate. As intended by Congress, the move to 100% exclusion has spurred interest in investments into start-up and other small businesses by essentially creating fully tax-exempt gain, which has resulted in an increasing number of investors structuring investments with an eye toward QSB status.

Further, pass-through entities may make investments in QSB stock, and the gain exclusion applies at the ultimate investor level (i.e., the noncorporate shareholders such as an individual, trust or estate). As a result, the total gain exclusion on QSB stock sold by a pass-through entity may be significantly higher than the $10 million/10 times basis cap. For example, assuming all requirements of section 1202 are met, if a partnership with 10 partners (each owning 10%) sells its QSB stock with $0 basis for $100 million, then each partner may exclude its ratable share of the gain (i.e., $10 million per partner). The gain exclusion is not limited to $10 million; all $100 million of the gain qualifies for the exclusion because it is determined at the ultimate investor level.

However, many companies and investors may discover that satisfying all of the requirements of section 1202 is not simple, in particular when incorporating or acquiring an existing business with the hopes of attaining QSB status.

Requirements and considerations

Generally speaking, a QSB is a domestic C corporation² with aggregate gross assets of $50 million or less at all times before and up through immediately after the issuance of the stock for which the gain exclusion is sought. Section 1202 contains several key requirements that must be met and that are discussed in further detail below. The below discussion is not an all-encompassing analysis of the rules of section 1202, but rather is intended to identify significant issues that a business or investor should consider when looking at qualification as a QSB. The requirements under section 1202 include, among others:

Original issuance requirement: The shareholder of QSB stock must have acquired the QSB stock at its original issuance in exchange for money, property other than stock or services provided to the issuing corporation.³ Generally, the term original issue refers to an issuance of stock directly from the corporation (or through an underwriter) to a qualified shareholder, and not to the timing of the issuance of stock. In other words, it does not mean that only a corporation’s first issuance of stock upon its incorporation is considered QSB stock. Acquiring corporate stock from an existing shareholder will not satisfy the original issuance requirement; however, it may be possible for investors to create a new C corporation to acquire a target business and satisfy the original issuance requirement. Additionally, provided certain requirements are met and subject to limitations, certain tax-free reorganizations or incorporations in which QSB stock is exchanged for stock of another company may allow for continued gain exclusion on some or all of the gain on the later sale of the acquired stock.⁴

Certain transfers will not cause QSB stock to fail the original issuance requirement.⁵These transfers generally include transfers of QSB stock by gift or inheritance or a distribution by a partnership to a noncorporate partner (but only if the noncorporate partner held its partnership interest on the date the partnership acquired the QSB stock).⁶ Questions may arise as to whether the original issuance requirement is met in transactions involving cashless warrant exercises, convertible debt conversions or the satisfaction of debt for equity.

Active business requirement: The corporation must use at least 80% of its assets, measured by value, in the active conduct of one or more qualified trades or businesses (QTOB).⁷Additionally, if the corporation owns more than 50% (by vote or value) of a subsidiary corporation’s stock, then the corporation must include its ratable share of the subsidiary’s assets and activities in analyzing the active business requirement.⁸

A QTOB does not include, among others, any trade or business engaged in the performance of services in the fields of health, law, accounting, brokerage services, financial services, engineering, architecture, actuarial science, athletics, performing arts and consulting.⁹ Although these specific fields are enumerated in the statute, questions may arise as to whether certain business activities fall within these fields. For example, the “field of health” is likely not as broad as one may think, as companies that support health care service providers and patients but do not themselves provide services in the field of health might not be engaged in “health” for purposes of section 1202. What represents consulting is another significant issue, as the term “consulting” is vague and is not defined by section 1202 or the relevant regulations. Based on authorities outside of section 1202, may refer to the provision of advice and counsel when not provided in conjunction with other services, so distinguishing consulting from services such as operational management could be a significant consideration.

Gross asset test: As noted above, a QSB is generally a domestic C corporation with aggregate gross assets of $50 million or less. Generally, the aggregate gross assets of the corporation (and any of its predecessors) must not have exceeded $50 million at any time between Aug. 10, 1993, and the date of the issuance of the stock for which preferential treatment under section 1202 is sought.¹⁰ Additionally, the aggregate gross assets of the corporation immediately after the issuance must not exceed $50 million.¹¹ The gross asset test is generally based upon the tax basis of assets as opposed to fair market value.¹² However, when contributing property other than cash or incorporating an existing business, the fair market value at the time of the contribution is utilized in determining the aggregate gross assets of the corporation at the time of the issuance and for purposes of any future issuances.¹³ Additionally, all corporations that are members of the same parent-subsidiary controlled group (defined as more than 50% ownership) are treated as one corporation for purposes of determining the total gross assets.¹⁴

Per-issuer limitation on gain exclusion

Provided all of the requirements under section 1202 are met, the gain realized on the sale of the QSB stock is eligible for exclusion. As noted above, in determining the amount of excluded gain the investor must apply the per-issuer limitation. This limitation is generally the greater of:

1. $10 million, reduced by the aggregate amount of eligible gain realized by the taxpayer in a prior taxable year that is attributable to dispositions of stock issued by the issuing corporation to the taxpayer, or
2. 10 times the aggregate adjusted bases of the QSB stock that the taxpayer sold during the taxable year.¹⁵

This limitation is applied to eligible gain that is taken into account under section 1202(a) for the taxable year.¹⁶ Eligible gain is any gain from the sale or exchange of QSB stock held for more than five years.¹⁷ As discussed above, where QSB stock is held by a pass-through entity, the gain exclusion, and therefore the per-issuer limitation, is applied at the shareholder (i.e., investor) level to each investor. As a result, investors in partnerships (individuals, trusts and estates) may be able to claim a gain exclusion that is, in the aggregate, much greater than the $10 million/10 times basis cap. An individual may also be able to increase the gain exclusion amount by gifting some of the QSB stock to family members prior to the sale of such stock.

Conclusion

The section 1202 gain exclusion on the sale of QSB stock is a provision intended to incentivize investors to invest in small businesses. In recent years it has become a sought-after structure by investors. Section 1202 may be of significant benefit to many investors, but its requirements must be carefully analyzed in order to ensure eligibility for the gain exclusion. As illustrated above through some of the key requirements and considerations, the nuances of the section 1202 rules are complex. Taxpayers should consult with their tax advisors when considering claiming the section 1202 gain exclusion benefit.

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¹ Section 1202(a)(3), (4).

² Other than a domestic international sales corporation (DISC) or former DISC, a regulated investment company, real estate investment trust, real estate mortgage investment conduit, or a cooperative. Section 1202(e)(1)(B), (4).

³ Section 1202(c)(1). Additionally, the issuing corporation must have issued the stock after Aug. 10, 1993.

⁴ Section 1202(h)(4).

⁵ Section 1202(h)(1).

⁶ Section 1202(h)(2).

⁷ Section 1202(e)(1)(A).

⁸ Section 1202(e)(5).

⁹ Section 1202(e)(3).

¹⁰ Section 1202(d)(1)(A).

¹¹ Section 1202(d)(1)(B).

¹² Section 1202(d)(2)(A).

¹³ Section 1202(d)(2)(B).

¹⁴ Section 1202(d)(3)(A).

¹⁵ Section 1202(b)(1)(A), (B).

¹⁶ Section 1202(b)(1).

¹⁷ Section 1202(b)(2).