January 9, 2013

QSBS Requirements

QSBS is stock of a U.S. C corporation with gross assets less than $50M, both before and immediately after the issuance of the stock. All corporations that are a part of the same parent corporation are treated as one corporation.

The taxpayer must acquire the stock at its original issue, either in exchange for money, property, or as compensation for services.

A qualified trade or business is any trade or business other than:

  1. Health, law, engineering, architecture, accounting, actuarial services, or brokerage services
  2. Banking, insurance, financing, leasing, investing, or similar business
  3. Farming Business
  4. Production of products for which depletion can be claimed
  5. Hotel, motel, restaurant, or similar business

Exclusion of Gain from Sale of Qualified Small Business Stock (QSBS)

QSBS Sheet

50% Exclusion of Gain
IRC Sec. 1202 allows non-corporate taxpayers to exclude from gross income 50% of any gain from the sale or exchange of QSBS acquired before February 18, 2009 or after December 31, 2013. The stock must be held for more than five years.

The maximum tax rate on an individual’s net long-term capital gain for 2011 and 2012 is 15% and for 2013 is 20%. However, the capital gains rate applicable to QSBS sales is 28%. Therefore, the effective QSBS tax rate is 14% (50% x 28%). This amounts to an overall tax savings of 1% to 6% – a small tax benefit.

75% Exclusion of Gain
The 2009 Recovery Act increased the capital gain exclusion from the sale or exchange of QSBS held more than five years to 75% for stock acquired between February 18, 2009 and September 27, 2010. The effective QSBS tax rate becomes 7% (25% x 28%). This is less than half of the normal long-term capital gains rate and can create substantial savings for the taxpayer.

100% Exclusion of Gain
The 2010 Tax Relief Act increased the capital gain exclusion from the sale or exchange of QSBS held more than five years to 100% for stock acquired between September 28, 2010 and December 31, 2011. The 2012 Taxpayer Relief Act expanded this provision to include stock acquired between January 1, 2012 and December 31, 2013. Gains from QSBS purchased within these contiguous time frames are completely exempt from federal taxation! A 0% tax rate is a unique tax opportunity that has piqued the interest of many investors.

** Please note that the tax rates quoted above will vary if the taxpayer is in AMT.

Rollover of Gain from Sale of QSBS
In addition to the exclusion of gain provisions, QSBS benefits from a gain rollover election. Taxpayers may defer the taxable gain on the sale of their QSBS (“old QSBS”) by electing to rollover the gain to newly purchased QSBS (“new QSBS”). To make the rollover election, taxpayers need not meet the five-year holding period requirement related to the QSBS exclusion. Rather, the election can be made if the stock has been held more than six months. The new QSBS must be acquired within 60 days, beginning on the sale date of the old QSBS. Gain will not be recognized if the entire proceeds from the sale of the old QSBS are reinvested in the new QSBS. The basis in the new QSBS is the taxpayer’s purchase price less any unrecognized gain from the sale of the old QSBS.

In addition to these basic rules, the QSBS provisions are complex and filled with many nuances. For example, there are various specialized rules related to QSBS and pass through entities such as partnerships, rules related to the reorganizations of QSBS companies and rules related to the holding of short positions in QSBS stock. We encourage you to discuss your stock holdings and strategies with your tax preparer before claiming benefit under one of these provisions.

QSBS Restrictions
With regards to the excluded gain, the amount of excluded gain is limited in any year to the greater of 1) 10 times the taxpayer’s basis in the stock OR 2) $10 million reduced by eligible QSBS gain taken into account in previous years.

Due to a recent court case regarding the constitutionality of the California QSBS law (specifically their requirement that 80% of a Company’s property and payroll must be located in California), the California Franchise Tax Board has now taken the position that the entire California QSBS provision is null and void. On December 21st, the California Franchise Tax Board issued a notice (FTB Notice 2012-03) stating that they are disallowing the use of the provision not only for all current and future years, but also for all “open” tax years (taxable years beginning on or after January 1, 2008).

As such, the California Franchise Tax Board has started to send notices to taxpayers who have used the provision in past years. We have been in contact with various attorneys and others who are knowledgeable about this issue and many feel that the issue is far from resolved. In the next few months, we expect challenges to the Franchise Tax Board’s position.