Tax Reform Makes Multi-Million Dollar Tax Savings Technique Even More Viable by Barry M. Brant, CPA
Posted on December 07, 2017
The Federal Government in 2015 made permanent an often-overlooked benefit of the U.S. Tax Code that allows entrepreneurs, venture capitalists and angel investors to potentially exclude from their taxable income 100 percent of the gain from the sale of qualified small business stock (QSBS) held for a minimum of five years. This exclusion could be as much as $500 million per qualified small business. Furthermore, with the lowering of the Federal corporate tax rate to 21 percent effective January 1, 2018, more and more qualified small businesses should consider operating as regular (‘C’) Corporations. The key term to focus on here is “qualified,” since not all investors nor their investments will be eligible for a complete or even partial tax exemption under Code Section 1202.
What is QSBS?
Qualified Small Business Stock refers to the shares a corporation issued after August 10, 1993, to non-corporate investors who acquired original-issued stock by investing (or exercising stock options or warrants) in a corporation that meets the following requirements:
- It must be a C Corporation, including a previous LLC, partnership or S Corporation that converts to a C Corporation (but excluding a Subchapter S Corporation),
- It must be a qualified small business with gross assets of no more than $50 million on the date of and immediately after it issues stock to the investor or converts to C Corporation status, and
- It must use at least 80 percent of the value of its assets (including intangible assets) in the active conduct of a qualified trade or business for the duration of the period that taxpayers hold the stock.
Here’s where things can get tricky.
For one, a qualifying business may NOT involve the delivery of services that require specialized skills in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services or brokerage services. In addition, QSBS benefits will NOT apply to shares an investor holds in the following types of entities:
- banking, insurance, financing, leasing, investment and similar businesses;
- hotels, restaurants and similar hospitality businesses;
- farming businesses;
- businesses involving the production or extraction of products of a character for which percentage depletion is allowable (e.g. oil and gas exploration); and
- businesses in which more than 10 percent of the value of the company’s net assets consists of stock and securities of unrelated corporations or real property that is not used in the active conduct of a qualified trade or business. For this purpose, owning, dealing in, or renting real property is not considered to be the active conduct of a qualified business.
Do I Qualify for a Complete Exemption on Gains from the Sale of QSBS?
Under current law, taxpayers may exclude ALL of their capital gains from the sale or exchange of investment in QSBS stock when they meet the following conditions:
- They purchased the stock from an original issuer (i.e. the QSBS and not another shareholder) after September 27, 2010;
- They held the stock for more than five years;
- The issuing corporation does not redeem more than 5 percent of the aggregate value of all of its stock within one year before or after it issues stock to the eligible taxpayers; and
- The gain on any ONE investment in a QSBS does not exceed the GREATER of $10 million, or 10 times the adjusted basis of qualified stock the taxpayer disposes of in each entity during a particular tax year.
Importantly, this means that if an investor subscribed to QSBS after September 27, 2010, by investing $50 million in a newly formed corporation as the initial sole shareholder and subsequently sold the stock for an amount between $50 million and $550 million after a minimum of five years, he or she could exclude from tax the first $500 million of capital gain. This exclusion would also apply to the investor’s exposure to the 3.8 percent Net Investment Income Tax (NIIT), also known as the Obamacare Tax, and the Alternative Minimum Tax (AMT). To illustrate further, consider an investor who subscribed to QSBS after September 27, 2010, by investing only $1,000 into a new or existing corporation. If the investor held the stock for at least five years and then sold it for between $1,001 and $10,001,000, ALL of the gain (up to $10 million) would be exempt from tax, including the NIIT and AMT, under Section 1202.
How Does the QSBS Exemption Work?
Taxpayers issued QSBS after September 27, 2010, can elect to exclude 100 percent of their qualifying gain from federal income taxes, including the AMT and NIIT. For QSBS issued between February 18, 2009, and September 27, 2010, 75 percent of the qualifying gain can be excluded, with the remaining 25 percent subject to federal income tax at the rate of 28 percent. For QSBS issued between August 11, 1993, and February 17, 2009, investors may exclude from tax 50 percent of the qualifying gain; the remaining 50 percent will be subject to federal income tax at the rate of 28 percent.
Significantly, in the case of QSBS acquired before September 28, 2010, the 3.8 percent Net Investment Income Tax will apply to the qualifying gain excluded as will the alternative minimum tax on 7 percent of the excluded gain. The table below summarizes the different tax benefits investors may receive, depending on when a corporation issued the QSBS:
Date Issued Exclusion QSBS Effective Tax Rate Non-QSBS Effective Tax Rate
After 9/27/10 100% 0% 23.8%
2/18/09-9/27/10 75% 9.42% 23.8%
8/11/93-2/17/09 50% 16.88% 23.8%
It should be noted that although this potential planning opportunity may lead to significant federal tax savings, certain states, including California, do not follow federal income tax treatment of QSBS. As a result, these states tax their residents on the gain excluded under federal law.
In light of the significant tax saving opportunities offered by Section 1202, and with the likelihood that more small businesses will choose to operate as C corporations due to the low 21 percent Federal rate effective January 1, 2018, under the Tax Cuts and Jobs Act, investors should meet with experienced advisors and accountants to analyze their ownership of small businesses and venture capital opportunities. Consideration should be given to structuring these investment vehicles as C Corporations, which could yield tax savings and are typically the ideal entity of choice for institutional private equity investors that may invest at a later stage.
About the Author: Barry M. Brant, CPA, is director of Tax, Consulting and International Services with Berkowitz Pollack Brant, where he leads the firm’s private client group and provides guidance on complex tax matters, including multi-national holdings, cross-border treaties and wealth preservation and protection. He can be reached in the CPA firm’s Miami office at (305) 379-7000, or via email at firstname.lastname@example.org.