Congress Makes Permanent 100% Gain Exclusion on Qualified Small Business Stock
March 01, 2016
By Benjamin Aspir
The Protecting Americans from Tax Hikes Act (“PATH”) passed by Congress in December 2015 made permanent the 100% exclusion of gain on the sale of Qualified Small Business Stock (QSBS). The QSBS exclusion, also known as the Section 1202 exclusion, has been in effect for over 20 years. In the late 1980s, in Revenue Ruling 88-76, the IRS declared limited liability companies would be treated as partnerships for tax purposes. The revenue ruling was viewed by many as the beginning of the end of the use of C corporations as an entity choice, and the popularity of C corporations has decreased over the past 3 decades as a result of the ruling. However, the Section 1202 exclusion is a little-known benefit that C corporations have over other entity types. Section 1202 of the Internal Revenue Code was enacted in 1993 with the goal of encouraging long-term investment in startups and other small businesses by exempting capital gains from taxation on the sale of stock in these entities. Section 1202 allows holders of QSBS to exclude 50% to 100% of capital gains on the sale of QSBS, provided the stock meets all of the following criteria:
- Issued by a domestic C corporation with no more than $50 million of gross assets at the time of and immediately after issuance;
- 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 and types of businesses;
- Issued after Aug. 10, 1993;
- Held by a non-corporate taxpayer;
- Acquired by the taxpayer on original issuance; and
- Held for more than 5 years.
The percentage of gain on the sale of QSBS excluded from federal income tax is determined 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. Prior to 2013, the maximum long term capital gains rate (“LTCG”) rate was 15% and the effective tax rate on Section 1202 gains was 14%, giving taxpayers little incentive to claim the Section 1202 exclusion. In 2013, LTCG rates increased to a maximum 23.8% and brought the benefits of Section 1202 into the spotlight. From the choice of entity decision at inception to potentially converting to a C corporation, there are planning opportunities available which may allow taxpayers to benefit from the Section 1202 exclusion. If you have any questions, please contact your tax advisor. Stay tuned—we’ll be releasing more information on this topic.