Tax Law and Business Organization Strategy

Turning Startup Profits into 100% Tax-free Gains under the Qualified Small Business Stock Rules

Venture capitalists and private equity groups are reportedly taking an interest in structuring startups to qualify under the qualified small business stock (QSBS) provisions of Code Sec. 1202. It's not hard to see why — this often-overlooked Code provision can turn much or all of the profit on a successful investment in a startup into tax-free gain. But time may be of the essence: Under current law, the 100% exclusion won't apply for QSBS acquired after 2011.

Noncorporate taxpayers may exclude from gross income 100% of any gain realized on the sale or exchange of QSBS held for more than five years if the QSBS is acquired after Sept. 27, 2010 and before Jan. 1, 2012. The exclusion is 75% of gain realized on the sale or exchange of QSBS acquired after Feb. 17, 2009 and before Sept. 28, 2010, and 50% of gain realized on the sale or exchange of QSBS acquired either before Feb. 18, 2009, or after Dec. 31, 2011 (but 60% instead of 50% for certain gain attributable to QSBS in a qualified business entity). Excluded gain is subject to a cumulative and annual dollar limitation.

Additionally, the alternative minimum tax (AMT) preference for a portion of gain from the sale or exchange of QSBS that is excluded from gross income for regular tax purposes under Code Sec. 1202 doesn't apply to QSBS acquired after Sept. 27, 2010 and before Jan. 1, 2012.

A noncorporate taxpayer's net capital gain that is adjusted net capital gain is taxed at a maximum rate of 15%. If the adjusted net capital gain would otherwise be taxed at a rate below 25% if it were ordinary income, it is taxed at a zero percent rate. Under current law, these rates are in effect through 2012. Net capital gain attributable to section 1202 gain (as well as collectibles gain) is taxed at a maximum rate of 28%. Section 1202 gain is the excess of (1) the gain that would be excluded from gross income on the sale of certain QSBS under Code Sec. 1202, if the percentage limitations of Code Sec. 1202(a) didn't apply, over (2) the gain actually excluded under Code Sec. 1202.

Qualifying as QSBS. Stock qualifies as QSBS only if it meets all of the following tests.

  1. It must be stock in a C corporation (that is, not S corporation stock) originally issued after Aug. 10, '93.
  2. As of the date the stock was issued, the corporation was a domestic C corporation with total gross assets of $50 million or less (a) at all times after Aug. 9, '93, and before the stock was issued, and (b) immediately after the stock was issued. Gross assets include those of any predecessor of the corporation, and all corporations that are members of the same parent-subsidiary controlled group are treated as one corporation.
  3. In general, the taxpayer must have acquired the stock at its original issue (either directly or through an underwriter), either in exchange for money or other property or as pay for services (other than as an underwriter) to the corporation.
  4. During substantially all the time the taxpayer held the stock:
  • The corporation was a C corporation;
  • At least 80% of the value of the corporation's assets were used in the active conduct of one or more qualified businesses; and
  • The corporation was not a foreign corporation, domestic international sales corporation (DISC), former DISC, regulated investment company (RIC), real estate investment trust (REIT), real estate mortgage investment conduit (REMIC), financial asset securitization investment trust (FASIT), cooperative, or a corporation that has made (or that has a subsidiary that has made) a Code Sec. 936 election.

Active conduct of a qualified business. For purposes of the rule requiring 80% of the value of assets to be used in the conduct of a qualified business, all of the following are treated as used in the active conduct of a qualified business:

  1. Assets used in certain activities with respect to future qualified businesses, without regard to whether the corporation has any gross income from these activities at the time this rule is applied. Those activities are (a) Code Sec. 195(c)(1)(A) startup activities, (b) activities that result in the payment or incurrence of qualifying research and experimental expenditures under Code Sec. 174, and (c) activities with respect to in-house research expenses.
  2. Assets held to meet the reasonably required working capital needs of a qualifying business, and assets held for investment that are reasonably expected to be used within two years to finance research and experimentation in a qualified business or to finance increases in working capital needs of such a business. But, after the corporation has been in existence for at least two years, no more than 50% of its assets may qualify as being used in the active conduct of a qualified business by reason of these rules.
  3. The rights to computer software which produces active business computer software royalties as defined in Code Sec. 543(d)(1)

 

A corporation will be treated as failing to meet the active business requirement for any period during which: (1) more than 10% of the value of its assets in excess of its liabilities consists of stock or securities in other corporations which are not subsidiaries of the corporation, other than working capital assets; or (2) more than 10% of the total value of its assets consists of real property which is not used in the active conduct of a qualified business (for this purpose, owning, dealing in, or renting real property is not considered to be the active conduct of a qualified business).

Note that a corporation will be treated as meeting the active business requirement for any period during which it is a specialized small business investment company (SSBIC).

Qualified business. For QSBS purposes, a qualified business is one that isn't:

  1. A business involving services performed in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services.
  2. A banking, insurance, financing, leasing, investing, or similar business.
  3. A farming business (including the raising or harvesting of trees).
  4. A business involving the production of products for which percentage depletion can be claimed.
  5. A business of operating a hotel, motel, restaurant, or similar business.

Dollar limit on eligible gain. For each tax year, for each corporation in which the taxpayer sells or exchanges QSBS, the amount of gain eligible for the exclusion can't exceed the greater of:

  1. $10 million ($5 million for married persons filing separately), less the total amount of eligible gain (i.e., gain on the sale or exchange of QSBS held for more than five years) taken into account under the Code Sec. 1202(a) rules by the taxpayer with respect to dispositions of stock issued by the corporation in all earlier tax years, or
  2. ten times the taxpayer's total adjusted basis in QSBS of the corporation disposed of by the taxpayer in the tax year.
     
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