By: Eliot Goldberg, CPA, Principal – WithumSmith+Brown, PC
Congress passed the 2015 PATH Act on December 18, 2015 in which it made certain tax provisions permanent. Generally, those provisions had repeatedly been extended for one or two years, frequently on a retroactive basis.
One such provision made permanent is the exclusion for 100% of the gain realized on the sale of “qualified small business stock” (QSBS) under Internal Revenue Code (“IRC”) section 1202.
The exclusion applies to both the regular tax and the alternative minimum tax (“AMT”) and, further, to the 3.8% net investment income tax (“NIIT”).
The exclusion is available to non-corporate taxpayers who realize a gain on the sale of QSBS held for more than five years and acquired after September 27, 2010. The gain to be excluded is subject to a maximum amount per shareholder on the stock of any single issuer. The limitation on the gain that can be excluded is the larger of either:
1. Ten times the taxpayer’s basis (without taking into account increases in basis after the original stock issuance) disposed of during the tax year, or
2. $10 million ($5 million if married filing separately) but reduced by amounts excluded in prior years on the same corporation’s QSBS.
Qualified small business stock is:
a. Stock in a corporation (excluding REITs, REMICs, DISCs and cooperatives) that was, for substantially all of the taxpayer’s holding period, a “C” corporation;
b. In a corporation that carries on (an) “active business(es)”;
c. Acquired at its original issue directly or through an underwriter;
d. Acquired in exchange for cash, property or as compensation for services;
e. In a corporation whose aggregate gross assets cannot be more than $50 million both at any time before as well as immediately after the stock has been issued.
The active trade or business requirement is that at least 80% of the value of the corporation’s assets must be used by the corporation in the active conduct of one or more qualified trades or businesses (“QTOBs”). QTOBs generally exclude businesses that involve the performance of services or rely principally on the reputation or skill of one or more employees. The 80% minimum is, under a better view, required to be consistently maintained. It can, however, include reasonably required working capital, and may also include assets used for start-up activities or research and experimentation as both are defined in the Internal Revenue Code (“Code”).
There are anti-evasion rules associated with the requirement that the stock be newly issued that address situations involving repurchases, transfers, and redemptions that would disqualify shares subsequently acquired, presumably as “originally issue”.
While it is not uncommon for start-up businesses to elect S corporation status to pass through anticipated losses in early years, care must be given as to whether such an election results in a corporation not being a C corporation for “substantially all” of the stock’s holding period.
Incorporations of partnerships may qualify if the requisite tests are met including the gross assets test. This test looks to the fair market value of contributed property. Parent-sub controlled groups are also aggregated for this purpose. Once this test has been met, assets may grow and not disqualify the corporation from QSBS treatment.
This, now permanent, tax provision is a powerful tool to be utilized by private equity, venture capital as well as other managers. For these types of funds with a large U.S. taxable individual investor base (or fund of funds), the resulting after-tax return differential can be very meaningful. Funds may want to counsel portfolio entities into conformance in order to take advantage of this provision.
For more information on the Qualified Small Business Stock tax exemption or any other tax matters, please contact your regular Withum partner or any member of the Withum financial services group.