Dissecting the Qualified Small Business Stock Exclusion

DP: I'm glad you're here today Ben because this seems like an issue that's full of wrinkles, and I'm glad you're here to sort it out for us. Tell us about the QSBS Section 1202 exclusion and what's involved?
BA: I'm glad to provide some clarity. 1202 is a tax code section enacted by Congress in the early 1990s as a way to spur long-term investment in startups and small corporations. And what 1202 does is it exempts a portion of capital gains tax on qualified small business stock, or as I'll refer to a QSBS, and the C corporations have actually become more popular recently due to this 1202 exclusion. You might be wondering why I haven't really heard of this 1202 exclusion. It has pretty much been ignored due to the low capital gains tax rates. Previously, the top tax rate on capital gains, which was 15%, and 14% was the effective rate on 1202. There's only a 1% difference if you benefited from this exclusion. But two things happened along the way that made the 1202 popular: Congress raised the top capital gains rates to 20% percent, and last year it made this exclusion permanent and up to 100% of gain.
DP:This is something that people should now have on their radar.
BA: Absolutely. In your order for stock to be eligible for the 1202 exclusions, there are two levels of requirements: one at the corporate level and one at the shareholder level.
DP:Tell us about at the corporate level.
BA: At the corporate level, the stock must be issued by a domestic C corporation. It can't be issued by a partnership or an S corporation. Additionally, the assets of the company issuing the stock may not exceed $50 million before and after the issuance of the stock. As original owner, as a C corporation, your assets, or very little at the beginning, your initial shares are almost always going to be eligible for the 1202 exclusion. If you have a capital raise and eventually your assets in your corporation are $20 million and you have a $40 million capital raise, the stock issue during that capital raise would not be eligible for the 1202 exclusion.
BA: However, any stock you previously owned before this capital raise would be eligible and it will not be negated. Additionally, the stock must be issued by a corporation that uses at least 80% of his assets in an active trader business. If you're a bank or any type of investment-type company that would just hold cash or securities, it's not considered an act of trade and must operating in an eligible industry, which I'll cover a little later. Lastly, the stock must be issued after August 10, 1993.
DP: Now let's turn our attention to the shareholder level. What do we need to know?
BA: At the shareholder level, the stock must be held by a non-corporate taxpayer. And when I say non-corporate taxpayer, it can't be held by a C corporation. They can't be the owners of the QSBS. It can be held through a partnership. If I decided to form an investment partnership and that investment partnership purchases a QSBS, that would be fine under 1202. Another requirement is it must be acquired on original issuance. You cannot purchase this stock on a secondary market or from your friend. That will not be considered original issuance. Lastly, the QSBS must be held for more than five years. You purchased this QSBS stock and you have to hold it before you sell it for five years to be eligible for the exclusion. If you sell beforehand, you would not get any benefit from this exclusion.
DP:Is it true an eligible stockholder could sell their QSBS and pay no tax on it?
BA: Yes. If the stars align and you hit all the requirements, it is technically possible if you have a large gain and not pay any tax on it.
DP:That’s great; good to know.
BA:It depends on when the stock was issued. If the stock was issued from August 11, 1993, through February 17, 2009, you will get a 50% gain exclusion. If the stock was issued from February 18, 2009, through September 27, 2010, you'd get a 75% exclusion, and any stock issued after September 28, 2010, would be eligible for a 100% exclusion. I'll cover the effects on the state level a little later. It's important to note the maximum gain eligible for exclusion is $10 million or 10 times what you paid for the stock. If you sell your stock for $20 million and you're eligible for 100% exclusion, you could have excluded the first $10 million on your stock.
DP:Do I need to hold the QSBS personally, or can I enter it through an entity such as a partnership?
BA:You don’t need to hold it personally. It can be held in a partnership or an S corporation. It just can't be held by a C corporation.
DP:What types of companies predominantly benefit? For example, are there any types of industries that are excluded from this?
BA:Any personal services-type of industry: an engineering firm, doctor, lawyer, attorney, accountant. Any type of a hospitality business, even if I'm a farming business, will not be allowed for this 1202 exclusion.
DP: If I sell QSBS eligible shares and then invest in another qualified small business, can I maintain an initial holding period?
BA:Yes. There is a specific provision in the revenue code, called Section 1045. What 1045 allows you to do is if you hold 1202 stock for more than six months and you identify another company you would like to invest in and you sell that initial 1202 stock, you can roll the gain into the new company if you purchase that new stock within 60 days. Now, you might say, Ben, didn't you say that you have to hold the stock for five years in order to be eligible for the gain? This provision is a tax deferral provision. It allows you to defer gain into the new stock and not pay any tax at the purchase of the new stock.
DP: The QSBS exclusion, tell us how that fits in with state taxes.
BA:As is the case with most tax questions I get from my clients, it depends. I can tell you New York does follow the 1202 solution, but New Jersey and Pennsylvania do not; California does not. It really depends on a state-by-state basis.
DP:Anything else we need to know about this exclusion?
BA: I tried to give a top-level overview of 1202. It's important that you consult your tax advisor if you encounter this issue. Make sure to ask questions.
DP: Thanks for dissecting this for us, Ben, because it looks like there's really a lot of nooks and crannies here. Visit eisneramper.com for more information on this and a host of other topics, and join us for our next EisnerAmper podcast when we get down to business.