A permanent exclusion for qualified SMB stock means big change
The extension of the exclusion for gains on qualified small-business stock by the Protecting Americans from Tax Hikes Act of 2015 may change the way some small businesses are funded.
Although the exclusion has existed in a variety of forms since 1993, it was in 2010 that it came to the forefront of startup planning when the exclusion rate was increased to 100 percent. And despite the 100 percent exclusion rate, it has not been widely used as a vehicle to fund startup businesses because of its uncertainty — it was one of the extenders that were periodically re-enacted, sometimes retroactively. The enactment of PATH has changed that by making permanent the Section 1202 exclusion, adding certainty to the planning for new ventures and small businesses, according to CohnReznick partners Dave Logan and Asael Meir.
“Now, founders and investors can plan their investment activities with this in mind,” said Logan. “Until now, the vehicle typically used by investors was convertible debt.”
“For example, an investor comes in with $10 million as convertible debt,” Meir said. “Five years later the company sells, and the investor will receive $100 million. The investor will be taxed on capital gain at a 25 percent rate.”
But take the same scenario, except that from Day One the investor put in $10 million for stock and sells for $100 million. “Potentially, the whole $100 million is excluded,” said Meir.
BUILDING, NOT BETTING
“Section 1202 encourages holding and not speculating,” noted Marty Davidoff, of E. Martin Davidoff and Associates. “This is good for small businesses, and small businesses are the economic locomotive.”
“What’s really good is that Congress is starting to add certainty throughout the Tax Code,” he added. “The constant rush to legislate extenders at the end of the year has been silly — making these permanent is a good thing.”
“Although this is not targeted at the mom-and-pop businesses, at some point when a business becomes large enough that outside investors may be interested in it, any benefit helps,” observed Roger Harris, president of Padgett Business Services.
The excludible amount is the greater of $10 million or 10 times the aggregate adjusted bases of qualified small-business stock issued by the corporation and disposed of by the taxpayer during the tax year.
In order to qualify for the exclusion, the stock must be qualified small-business stock, and it has to be held for more than five years, Logan noted.
“The company has to be a C corp, and the stock has to be acquired by the taxpayer at original issue, and at all times prior, including the transaction when the acquisition takes place, the gross assets of the corporation have to be $50 million or less,” he said. “That includes the transaction, so when you acquire the stock, that funding is included. It can grow afterwards, but at the date of the acquisition, the assets have to be $50 million or less, including the amount contributed.”
Specifically, the requirements under Code Sec. 1202 to qualify for the exclusion include:
- The qualified small-business stock must be from a C corporation.
- The taxpayer must be a non-corporate taxpayer.
- The qualified small-business stock must be held for more than five years.
The stock must have been acquired by the taxpayer at original issue, either directly or through an underwriter, in exchange for money or property, not including stock or as pay for services provided to the corporation (other than services performed as an underwriter of the stock).
The C corporation must have total gross assets of $50 million or less at all times after August 9, 1993, and immediately after it issues the stock.
In addition, there is an active business requirement. During the taxpayer’s holding period of the stock, at least 80 percent of the corporation’s assets must be used in the active conduct of one or more qualified trades or businesses.
“It can’t be a service organization, such as an accounting firm, or a law firm relying on members’ expertise to provide to clients,” Logan said. “It has to be held for more than five years, and the entity that owns the stock must be a non-corporate owner. There’s a special rule for partnerships, but it is limited to what happens afterwards. If you’re in a partnership and the partnership buys stock, it can qualify, but the exclusion would not work for any new partner.”
Other businesses that are not “qualified trades or businesses” are banking, insurance, financing, leasing, investing, or similar businesses; any farming business; any business involving the production or extraction of products for which percentage depletion can be claimed; or any business of operating a hotel, motel, restaurant, or similar business, Logan indicated.
To preserve the possibility of the exclusion, care should be taken in the form that the financing takes, he noted. “Equity should be considered versus other forms because of the potential exclusion. Often, founders are not aware that they’re holding qualified stock. They’re not aware of the exclusion,” he said. “On exit planning, make sure it is the stock that is being sold for value, as opposed to selling the assets in the C corporation.”
“For example, if I own a software company and sell the code, I pay tax on it as an asset sale, but if I sell the stock in the corporation it can quality for the exclusion,” Meir said. “This provision has been under the radar, so it’s important to advise your clients that may have such holdings to see if the stock would qualify. If they sell if after four and one-half years, they won’t get the exclusion, but if they hold it for an additional half year they could possibly exclude all their gain.”