Qualified Small Business Stock Gain Exclusion -- Now More Relevant Than Ever
- Aug 31, 2020
In the late 1980s, the IRS declared that limited liability companies (LLCs) could be treated as partnerships for tax purposes. This decision allowed an LLC to enjoy only one level of taxation. Conversely, C corporations pay an entity-level income tax while its shareholders pay tax when dividends are distributed. Many viewed this IRS decision as the beginning of the end for C corporations as an attractive entity choice. However, there have been two major favorable changes that have occurred for C corporations: 1) the enactment of IRC Sec. 1202 in 1993 and 2) the permanent reduction of corporate income tax rates from 35% to a flat 21% as of January 1, 2018.
IRC Sec. 1202 was enacted with the goal of encouraging long-term investment in startup companies and other small businesses by exempting capital gains taxes upon the sale of stock in these entities. Accordingly, IRC Sec. 1202 allows holders of qualified small business stock (QSBS) to exclude between 50% to 100% of capital gains upon the sale of QSBS provided the stock meets all of the following criteria:
- Issued by a domestic C corporation which had no more than $50 million of gross assets (since inception) and immediately after issuance of the stock;
- Issued by a corporation that uses at least 80% of its assets (by value) in an active trade or business, other than in certain personal services businesses;
- Issued after Aug. 10, 1993;
- Held by a non-corporate taxpayer;
- Acquired by the taxpayer on original issuance; and
- Held for more than five years.
The percentage of gain on the sale of QSBS excluded from federal income tax is determined based on the date the QSBS was issued as follows:
- QSBS issued from August 11, 1993 – February 17, 2009 = 50% gain exclusion;
- QSBS issued from February 18, 2009 – September 27, 2010 = 75% gain exclusion;
- QSBS issued from September 28, 2010 – Present = 100% gain exclusion.
The amount of gain eligible for exclusion is limited to the greater of $10 million or 10 times the taxpayer’s basis in the QSBS.
Presently, IRC Sec. 1202 is more relevant than ever. The COVID-19 pandemic has made it necessary for Congress to pass major economic stimulus. Taxes will likely be raised in order to offset the cost of the stimulus as well as lost tax revenue from the economic downturn. Therefore, IRC Sec. 1202 provides an opportunity to potentially shield future capital gains from federal taxation. A tax professional should be consulted in order to determine potential eligibility.
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Benjamin Aspir is a Senior Manager and a member of the firm’s National Tax Group, with more than 10 years of public accounting experience. He has extensive experience with IRC Section 1202 - Qualified Small Business Stock and advising cannabis clients on IRC Section 280E, within the Manufacturing and Distribution practice.
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