On December 17, 2010, President Obama signed the 2010 Tax Relief Act into law, and among other things, extended the 100-percent tax exclusion from capital gains of qualified small business stock (QSBS). As background, on September 27, 2010, President Obama signed H.R. 5297 Small Business Jobs Act of 2010 (P.L. 111-240) into law, creating additional tax incentives for businesses and individuals. The purpose of the Small Business Jobs Act is to encourage entrepreneurs and small business owners who may be sitting on the sidelines to make new investments and stimulate the economy. The expansion of existing Internal Revenue Code (Code) Section 1202 offered a way to fully exclude future tax gains to increase the after-tax return on the investment. Originally, this 100-percent tax exclusion from capital gains of qualified small-business stock (QSBS) expired at the end of 2010, but the 2010 Tax Relief Act extends the acquisition date to small business stock acquired on or before December 31, 2011. Under previous pre-2010 versions of the law, stockholders were generally permitted to exclude from recognition only 50 percent of the capital gain on the sale of QSBS, or 75 percent of the capital gain on such stock acquired after February 17, 2009 and before January 1, 2011.
QSBS may generally only be issued by a “qualified small business,” within the meaning of Code Section 1202, which generally requires that the issuer:
- be a domestic C corporation;
- have aggregate gross assets which, at all times on or after August 10, 1993, through and immediately following the issuance of the QSBS, do not exceed $50 million; and
- agree to submit such reports to the IRS and shareholders as the IRS may require to carry out the purposes of Section 1202.
A qualified trade or business specifically includes startup companies and certain research and experimentation activities. The term is otherwise defined as any trade or business other than certain specifically excluded activities (for example, professional activities such as law or medicine, banking and finance, farming, mining, and the operation of hotels and restaurants). In addition, certain entities that enjoy special tax privileges under other Code sections are excluded from the definition of an “eligible corporation,” e.g., domestic international sales corporations, regulated investment companies, real estate investment trusts and cooperatives may not issue QSBS.
Section 1202 also requires that securities meet the following conditions in order to qualify as QSBS:
- The stock must be “originally issued” to the taxpayer by a corporation that is a qualified small business on the date of issuance;
- During substantially all of the taxpayer’s holding period, at least 80 percent (by value) of the corporation’s assets must be used in the active conduct of one or more qualified trades or businesses;
- The corporation must be an “eligible corporation” during substantially all of the taxpayer’s holding period;
- The corporation may not (directly or indirectly) redeem more than a de minimis number of shares held by a taxpayer to which the QSBS is issued, or certain related parties, within a four-year period beginning two years prior to the issuance of the QSBS; and
- There may be no “significant redemptions” of the issuing corporation’s stock from any party during the two-year period beginning one year prior to the QSBS’s issuance.
To qualify for the exclusion, the gain, in any given tax year, from the sale or exchange of qualified business stock issued by a single issuer may not exceed the greater of:
- $10 million ($5 million for married taxpayers filing separately) reduced by the aggregate amount of eligible gain realized in prior taxable years attributable to dispositions of stock issued by such corporation; or
- 10 times the aggregate adjusted basis of qualified small business stock issued by such corporation and disposed of during the current taxable year.
Although the QSBS exclusion can provide significant tax benefits, some of the requirements and limitations may in the end make the structure not suitable for all startup investments. Entrepreneurs raising capital should analyze the various options available to them to maximize the potential return on investment for their investment.