What is qualified small business stock?
February 25, 2008
Under Internal Revenue Code Section 1202 , a taxpayer (other than a corporation) that recognizes gain from the sale or exchange of “qualified small business stock” held for more than five years may exclude 50% of such gain from gross income for regular income tax purposes. The amount of gain that may be taken into account for purposes of the exclusion is subject to a limitation equal to the greater of: (i) $10,000,000 (less previously excluded gain attributable to the disposition of other shares issued by the company), or (ii) 10 times the aggregate adjusted basis of the shares. In addition, a portion of the excluded gain is included in the calculation of alternative minimum taxable income.
Under IRC Section 1045, an individual may roll over proceeds from the sale of a qualified small business stock held for at least six months, when the proceeds are used to purchase qualified small business stock in another company. This effectively defers the tax due on any gain on the stock.
However, the maximum tax on long-term capital gains is 15% for most taxpayers and a 28% rate applies to gain on qualified small business stock. The effective tax rate after the 50% exclusion is 14%. Therefore, there is no substantial benefit to qualified small business stock unless the gain is rolled over into other qualified small business stock.
Qualified small business stock is defined in Section 1202 as any stock in a qualified small business issued to the taxpayer after August 10, 1993 in exchange for money or other property (not including stock), or as compensation for services. A qualified small business is a domestic C Corporation in which the aggregate gross assets of the corporation at all times since August 10, 1993 up to the time of issuance do not exceed $50,000,000. However, stock will not be considered to be qualified small business stock unless during substantially all of the taxpayer’s holding period the corporation meets certain “active business” requirements.
Stock issued by an S corporation does not qualify as qualified small business stock (even if the S election is later revoked), although subsequently acquired stock may qualify.
In general, gain from stock issued to “flow-through entities” such as partnerships and S corporations should qualify under Section 1202. However, the amount of the qualifying gain is limited to the interest held by the partner or S corporation shareholder on the date the stock is acquired. This limitation may be significant in certain venture fund settings when the general partners’ interests fluctuate over time.
Please note that certain redemptions, including (i) redemptions of stock from the holder of qualified small business stock (or a related person) and (ii) certain significant redemptions occurring within one year before or after a stock issuance may disqualify any newly issued stock.
[Note: please go ask your own tax advisors any questions about qualified small business stock because I will not answer technical questions in the comments.]