Investment Companies Advisor: Qualified Small Business Stock: Requirements and Benefits

Do you invest in new ventures, small businesses, or specialized small business investment companies? If so, Internal Revenue Code Section 1202 may provide relief to you. Knowing the qualified small business stock (QSBS) requirements can provide you with significant tax savings as it relates to your investment portfolio.

Opportunities exist for noncorporate taxpayers who dispose of QSBS in a taxable transaction to exclude the entire gain for federal tax purposes. The tax treatment for an owner of QSBS depends on how long the QSBS is held and when it was acquired. Noncorporate investors may exclude up to 100 percent of the gain they realize on the disposition of QSBS issued after September 27, 2010, and held for more than five years. The exclusion is 75 percent for stock acquired after February 17, 2009, and before September 28, 2010, and 50 percent for stock acquired before February 18, 2009. It important to note that the above focuses on the federal treatment of QSBS. Some states follow federal treatment while others may not.

The PATH Act, passed December 2015, had favorable implications as it relates to QSBS. The PATH Act made several tax breaks permanent including the exclusion of 100 percent of the gain on the sale or exchange of QSBS acquired after September 27, 2010, and held for more than five years. The PATH Act also permanently extended the rule that eliminates 100 percent excluded QSBS gain as a preference item for Alternative Minimum Tax (AMT) purposes. Furthermore, QSBS gain excluded from income is not subject to the Net Investment Income Tax.

What is qualified small business stock? Several requirements must be met to benefit from the QSBS exemption. A qualified small business is defined as a domestic C corporation. The corporation may not have more than $50 million in assets both before and immediately after the date the stock was issued. The stock must have been acquired at original issuance in exchange for money or other property (not including stock), or as compensation for services. Qualified stock acquired by exercising options or warrants or by converting debt is deemed acquired at original issue. Qualified stock that is converted to other stock of the corporation (such as preferred stock) also remains qualified stock.

During substantially all of the holding period, the corporation must also meet the “active business test:” At least 80 percent of the value of the corporation’s assets must be used in the active conduct of one or more qualified trades or businesses. Assets used in the active conduct of a trade or business include assets used for start-up activities, research and experimentation, and in-house research.  Also included are assets held as part of a corporation’s reasonably required working capital needs and assets held for investment that are reasonably expected to finance research and experimentation or increased working capital within two years. After a corporation has existed for two years, no more than half of its assets can be working capital or investments held for future research or working capital. In addition, the rights to computer software which produce active business royalties are also treated as assets used in the active conduct of a trade or business. It is important to note that owning, dealing, or renting real property does not constitute the active conduct of a trade or business. No more than ten percent of the corporation’s total asset value can consist of real property not used in the active conduct of a trade or business. In addition, no more than ten percent of the corporation’s asset value (in excess of liabilities) can consist of portfolio stock or securities of any other corporation which is not a subsidiary. The active business requirement is waived for specialized small business investment companies (SSBIC).

The definition of a qualified trade or business specifically excludes professional services such as law, accounting, architecture, health care, engineering, actuarial science, performing arts, athletics, financial services, brokerage services, consulting, or any other trade or business where the principal asset of the trade is the reputation or skill of one or more of its employees. Also excluded are banking, financing, farming, mining, hotel and restaurant management, and mineral extraction industries.

Stock will not qualify for the QSBS exclusion if the issuing corporation engages in a “significant redemption” meaning that within the period beginning one year before and one year after the stock was issued, the corporation cannot have bought more than a de minimus amount of its stock from anyone, unless the total value of the stock it bought is 5% or less of the total value of all its stock. The QSBS exclusion is also not available if the issuing corporation redeems its own stock from the taxpayer or persons related to the taxpayer within the four-year period beginning two years before and two years after the stock was issued unless the total value of the stock it bought is 2% or less of the total value of all its stock. It is advisable to communicate with company management during the holding period to make sure that QSBS requirements are met.

Gain on disposition of qualified stock held by a pass-through entity for more than five years is excludable when passed through to the partners, shareholders, and participants who held interests in the entity when it acquired the stock and at all times thereafter. However, if a partner, shareholder, or participant acquires additional ownership interest in the pass-through entity after the entity acquires the QSBS, the portion of the gain related to the new ownership interest is not excludable.

Although there are gain exclusion limitations, these limitations are very generous. The eligible gain which can be excluded from any single issuer for any given tax year is limited to the greater of (1) $10 million (reduced by the aggregate amount of eligible gain on the issuer’s stock that the taxpayer excluded in prior years) or (2) 10 times the adjusted basis of the investment.  For purposes of calculating the $10 million or 10 times adjusted basis ceiling in the context of a partner in a pass-through entity, the partner’s basis is determined to be their share of the partnership’s basis in the stock and the $10 million threshold applies on a per partner basis.

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If you hold an investment that you suspect may fit the QSBS requirements, you should consult with your tax advisor. Your tax advisor needs to know whether you have fulfilled the five-year holding requirement when the stock is sold. You should maintain proper documentation of the acquisition date and sale date of the QSBS stock. If you have an interest in a partnership that has sold QSBS, the partnership’s tax preparer will need to include appropriate footnotes on the K-1s. Otherwise, investors receiving a Schedule K-1 will not know that a portion of the partnership’s overall long term capital gain activity is from QSBS and should be either excluded from tax or taxed at a reduced rate on their underlying tax returns. Being aware of QSBS requirements, along with communication with your tax advisor, can result in large tax savings for you and your partnership’s investors.