Qualified Small Business Stock Changes Explained

An explanation of the recent IRS changes impacting qualified small business stock.

Guest written by: Robert Tobey, Keiter Stephens

In an effort to stimulate the economy and to help innovation economy companies grow, Internal Revenue Code (IRC) §1202 provides an incentive to investors who risk their funds to finance these businesses.

A BRIEF HISTORY
For qualified small business stock (QSB) acquired after August 10, 1993 and before February 18, 2009 and held for a minimum of five years, non-corporate investors may exclude 50% of the gain realized from the disposition this stock. As part of the American Recovery and Reinvestment Tax Act of 2009, in order to stimulate the economy, the exclusion percentage was raised to 75% for QSB stock acquired after February 17 and before September 28, 2010 and held for a minimum of years. The Creating Small Business Jobs Act of 2010 further amended IRC §1202 to exclude 100% of gain from QSB stock acquired after September 27, 2010 and before January 1, 2011. Finally, the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 extended the deadline to QSB stock acquired before January 1, 2012. The President’s 2012 budget proposes to make this exclusion permanent.

IN NON-TECHNICAL TAX TERMS, WHAT DOES THIS ALL MEAN?

COMPANY CONSIDERATIONS

How does corporate stock qualify as QSB stock?
Corporate stock is treated as QSB stock only if it satisfies all of the following conditions:
1. the stock was originally issued after August 10, 1993, the original enactment date of IRC §1202;
2. the corporation issuing the stock is a domestic C corporation (i.e.: S corporations, partnerships, and LLC’s taxed as partnerships do not qualify);
3. the stock satisfies the original issuance requirement (i.e.: stock is issued by the corporation to the shareholder directly or through an underwriter);
4. the corporation issuing the stock meets the QSB requirements; and
5. the corporation issuing the stock satisfies the active business requirements.

How does a domestic C corporation qualify as a QSB?
In order to qualify as a QSB, a domestic C corporation must meet the following tests:
1. The corporation’s aggregate assets must not exceed $50 million at any time on or after August 10, 1993 and before the issuance of the stock for which IRC §1202 treatment is sought.
2. Immediately after the issuance of the stock for which IRC §1202 treatment is sought, the corporation’s gross assets, including amounts received for the stock, must continue to be no more than $50 million.

Describe the active business requirement.
A corporation meets this test if it uses at least 80% of the value of its assets in the active conduct of a qualified trade or business. As of this writing guidance has not been issued regarding when and how the 80% of assets determination is made.

What is a qualified trade or business?
A qualified trade of business is one other than:
1. A heath care provider; law, engineering, architecture, or accounting firms; actuarial or brokerage services, or any trade or business where the principal asset of such trade or business is the reputation of skill of one or more of its employees.
2. Any banking, insurance, financing, leasing, investing or similar business.
3. Any farming business
4. Any business involving the production or extraction of products subject to depletion.
5. Any hotel, motel, restaurant or similar business.

Will a corporation meet the active conduct of a qualified trade or business if it is only conducting
research and development activities with the hopes of producing a product (i.e.: start-up phase)?
Yes, if assets are used in start-up activities, activities resulting in the payment or incurring expenditures which qualify as IRC §174 research and experimental (R&E) expenditures, or activities with respect to in house research expenditures described in IRC §41(b)(4) assets used in these activities shall be treated a used in active conduct of a qualified trade or business. This determination is made without regard to whether or not the corporation has earned any income from its intended trade or business.

Are options or warrants to acquire QSB stock considered QSB stock?
No.

Can the QSB gain exclusion be preserved in tax-free reorganizations and in contributions to controlled corporations?
Yes in certain circumstances. A discussion of these circumstances is beyond the scope of this summary. If you would like more information about this, please telephone me.

Are there any types of transactions between shareholders and the corporation which would make the gain on the QSB stock ineligible for the exclusion?
Yes.
If the issuing corporation purchases any of its stock directly or indirectly from the taxpayer or a person related to the taxpayer within a four year period commencing two years before the stock was issued, the taxpayer cannot qualify for the exclusion. There is a safe-harbor de minimis amount which will not disqualify the gain from exclusion.

Stock will not qualify for the exclusion if the issuing corporation engages in a significant redemption. A redemption is significant if the corporation, within a two year period beginning one year before issuance of the stock, redeems stock with an aggregate value exceeding 5% of the aggregate value of all of the corporation’s stock. There is a de minimis exception for this also.

SHAREHOLDER CONSIDERATIONS

What are the dollar limits on the exclusion?
The amount of gain is subject to a per-issuer limitation. The cumulative per issuer limit is the greater of $10 million or 10 times the adjusted basis (i.e.: what you paid for the stock) of all qualified stock of the issuer that the taxpayer disposed during the year. Additions to basis are disregarded. This limitation can severely restrict the tax benefit of IRC §1202 in the event of a truly substantial windfall. These are shareholder by shareholder limitations. Taxpayers filing married separately split the $10 million limitation.

How is any gain in excess of the exclusion taxed?
As mid-term capital gain income taxed at 28%

How long do I have to hold (i.e.: own) the stock in order to qualify for the exclusion?
For more than five years.

When does my holding period start if I acquired the stock my converting notes or exercising warrants or options?

The holding period starts the date the note is converted or the date the options or warrants
are exercised.

How is the holding period measured if I exchange one type of QSB stock for another (e.g.:
convert preferred into common)?
The holding period of the old stock tacks on to the new stock. So the holding period commences when you first acquire QSB stock.

How is the holding period measured if QSB stock is acquired by gift or inheritance?
If QSB stock is acquired by gift or inheritance, the beneficiary’s holding period includes the period the QSB stock is held prior to the gift or bequest.

How is the holding period measured if the QSB stock is received from a partnership?
If a partner receives QSB stock from a partnership in which the partner held an interest when the partnership acquired QSB stock, a partner’s holding period generally includes the period the QSB stock is held by the partnership.

How is the holding period measured if the QSB stock is received in a tax free reorganization or
in return for a contribution to a controlled corporation?
The holding period of the QSB stock received in either of these transactions apparently does not include the holding period of QSB stock surrendered in the transaction.

How is the excluded gain treated for AMT purposes?
It depends on when the gain is realized. Effective with a taxpayer’s 2003 tax year, the fraction of excluded gain treated as a preference is 7%. This percentage is applicable for stock sales occurring on or after May 6, 2003. The 7% preference is scheduled to sunset at December 31, 2012. Unless this changes, for tax years 2012 and after, the preference will be 28% for QSB stock with a holding period beginning after December 31, 2000, 42% for other stock. For QSB stock acquired between September 28 and December 31, 2011, none of the gain excluded under IRC §1202 is a preference for purposes of calculation AMT income.

A detailed write-up, including examples, explaining the provisions of IRC §1202 is available by sending a request to rtobey@kshgs.com or ring me at 434.220.2800.

IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction(s) or tax-related matter(s) addressed herein. 1202