Focus on what counts
Insights

Sale of Qualified Small Business Stock – Qualifying for a Gain Exclusion

December 1, 2017
view all archive

The tax consequences upon sale of a company are of critical importance. However, many times, the decision of entity structure early-on in the lifecycle of the company may have a significant impact on the tax liability upon sale. As entity structure is evaluated, IRC 1202 should be a consideration. For many years the benefit of IRC 1202 was lessened as a result of lower capital gains rates and the alternative minimum tax “AMT” impact. However, legislation over the last several years has created more opportunities for IRC 1202 to be applied. Coupled with an ongoing interest in corporate tax reform, IRC 1202 needs to be a consideration again.

Sec. 1202 (Qualified Small Business Stock- “QSBS”) provides that non-corporate taxpayers selling QSBS stock qualify for at least a 50% exclusion on the qualifying gain on the sale and up to a 100% exclusion on the qualifying gain depending on when the stock was acquired. Partnerships may hold 1202 stock as well. AMT may partially limit the benefit for stock acquired prior to September 28, 2010. Qualified Small Business Stock acquired on or later than September 28, 2010 is eligible for a 100% exclusion for both regular tax and AMT.

The gain exclusion is limited to the greater of $10 million OR 10 times the aggregate adjusted basis of the QSBS investment. The gain exclusion limits apply on a shareholder by shareholder basis.

Generally the following must be met in order to qualify for the exclusion:

  1. The stock must have been directly acquired by original issuance from a United States domestic C corporation;
  2. The C corporation's tax basis in gross assets did not exceed $50 million, before and immediately after stock issuance;
  3. At least 80 percent of the Qualified Small Business assets are used in the active conduct of at least one “qualified trade or business” as defined; and
  4. The stock must have been held for more than five years.

The stock acquired must be at original issuance and acquired for cash or other qualified consideration;

  1. The person recognizing the gain must have acquired the stock “at its original issue”.
    1. The stock must have been purchased in a primary offering and not from a third party in a secondary offering.
    2. Stock must have been acquired in exchange for cash, property other than stock, or services.

Generally, the term “qualified trade or business” is any trade or business other than the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees.

The exit transaction must be a stock sale to fully obtain the benefit and not an asset sale. If the assets are sold, the corporation will pay tax on the gain. This is a significant consideration when deciding on the entity structure as there is rarely a definitive answer on how the sale will be structured.

Reorganizations and recapitalizations may hinder the ability to qualify for IRC 1202. Each fact pattern must be analyzed to determine if the corporation and the shareholder meet all of the requirements of IRC 1202. Additionally, the C corporation and shareholder must consent to supply documentation regarding QSBS therefore early planning is desirable.

Depending on the jurisdiction, certain states may have decoupled from this gain exclusion and therefore this may only be a Federal tax savings. One would need to review such rules as such is based on each individual’s home state.

If you would like any further information please contact your Citrin Cooperman advisor.

Shawn M. Howard is a tax partner and co-practice leader of the firm’s Government Contracting Practice. Shawn is currently based in the firm’s Bethesda, Maryland office. He has extensive experience providing various tax services including the review of federal and multi-state tax returns, and tax strategies for a variety of domestic and international clients, including government contractors, professional services firms, technology companies, and private equity firms. He can be reached at 301-654-9000 or at showard@citrincooperman.com.

Paul LiRosi is a tax director with over 10 years of public accounting experience providing tax compliance to closely held C and S corporations, large partnerships, and high net worth individuals.He can be reached at 646-979-6052 or at plirosi@citrincooperman.com.