What? I missed out on avoiding capital gains tax entirely? How could this have happened? Well, don't get too upset yet. You might not have been able to qualify in the first place. You might still qualify without having known about it. And even though you might miss out on the 100% exclusion, you might still qualify for a 50% or 75% exclusion instead.
Last fall, as part of the Small Business Jobs Act, Congress created a small window of opportunity for noncorporate investors in qualified small business stock (QSB Stock). Those who purchased qualified stock between September 27, 2010 and January 1, 2011 and hold it for at least five years will pay absolutely no tax on the capital gain when the stock is sold (the "100% Exclusion Provision"). Of course, the time has passed for taxpayers to plan into this benefit. However, this article is meant not only for those who planned (or may have stumbled) into Congress' late-2010 largesse, but also to explain how taxpayer's who missed the boat might still benefit.
The 100% Exclusion Provision did not involve passage of an entirely new statute, rather it involves a time-limited expansion of Section 1202(a) of the Internal Revenue Code, which, since its enactment in1993, has allowed a 50% exclusion of gain on QSB Stock held more than five years. In 2009, the 50% exclusion was expanded to 75% for QSB Stock acquired in 2009 and 2010. Then in late 2010, not only was the exclusion percentage increased by an additional 25% (to a total of 100%) for QSB Stock acquired between September 27, 2010 and January 1, 2011, but also any gains from QSB Stock purchased during that period were excluded from alternative minimum tax ("AMT"). The 50% and 75% exclusions do not offer any AMT relief.
To qualify for the exclusion (regardless of the percentage of capital gain excluded), the stock must be issued by a qualified small business, which is defined as a domestic C corporation whose aggregate assets do not exceed $50 million before or after the issuance of the stock. In addition to the limitation of the assets' value, the corporation must use at least 80% of its assets in one or more active trades or businesses. For this purpose, an active trade or business does not include (i) most professional services businesses; (ii) any banking, insurance, financing, leasing, investing, or similar business; (iii) any farming business (including the business of raising or harvesting trees); (iv) any business involving production or extraction of products that qualify for percentage depletion; and (v) any business of operating a hotel, motel, restaurant, or similar business. Generally included, however, are manufacturing, wholesale, retail and high technology businesses.
To be treated as QSB Stock, the taxpayer must hold "original issue" stock. Receipt of stock through gift or inheritance will not invalidate the stock as long as it was original issue to the person from whom the gift or inheritance came.
Example 1: In 2016, Individual A sells stock in XYZ Corporation for $500,000 million. A originally purchased the stock for $40,000 in November 2010. When A purchased the stock it qualified as small business stock under Section 1202. In 2016, A realizes capital gain of $460,000 ($500,000 - $40,000), but recognizes gain of zero. A is not required to pay any tax on the gain from the sale of qualified small business stock. If on the other hand, A had purchased the stock in August 2010, he would be required to pay capital gains tax on 25% of the gain or $115,000 ($460,000 × .25).
There is, however, a cap on the amount of gain that is eligible for the capital gains exclusion. The eligible gain for the tax year of disposition is limited to the greater of (i) $10 million reduced by eligible gain taken in previous years on qualified small business stock or (ii) ten times the basis in the taxpayer's QSB Stock. The limitation did not apply to the $460,000 gain in Example 1 because the amount is limited by the greater of $10 million or $400,000 (ten times the $40,000 basis in the stock).
As shown in Example 1, the additional 25% exclusion provided by the 100% Exclusion Provision can be significant when selling large blocks of stock that have appreciated substantially. However, Congress anticipated that the additional 25% by itself might not have been enough to encourage small investors to invest in American small businesses, so it also excluded gains from qualifying dispositions of QSB Stock purchased in this approximately three-month window from the AMT. Any gain excluded under Section 1202 with respect to QSB Stock acquired outside of this window is included as a tax preference item in the determination of the AMT.
Example 2: Assume all of the facts set forth in Example 1. In 2016, not only is the entire $460,000 gain excluded for income tax purposes, this exclusion is not treated as a preference item for AMT purposes. If on the other hand, A purchased the stock in August 2010, not only would A have to pay tax on $115,000, but the $345,000 exclusion would be included in the determination of alternative minimum taxable income./p>
Although the 100% Exclusion Provision is available only for shareholders who acquired QSB Stock between September 27, 2010 and January 1, 2011, shining a light on Section 1202 is a good thing because other exclusions may apply. Even before the Small Business Jobs Act expanded the exclusion to 100% for a limited period, we had come across other taxpayers who qualified for the prior basic 50% and expanded 75% exclusions. Although Section 1202 is riddled with technical requirements, it is not unusual to find C corporations capitalized or recapitalized after the 1993 enactment date of Section 1202 that qualify even though the shareholders did not plan to be able to take advantage of Section 1202. Serendipity or not, the benefit applies if the requirements are met.
Given the changing exclusion rates of QSB Stock, it is essential to have adequate documentation when blocks of stock have been purchased over several years. For instance, assume a taxpayer bought $20,000 of qualified stock in 2008, $10,000 in May 2009 and $15,000 in October 2010. When the stock is sold at least five years in the future, the taxpayer will recognize a 50% gain on the 2008 purchase, a 25% gain on the 2009 purchase and no gain on the 2010 purchase. In addition, all but the 100% exclusion are preference items in determining the AMT in the year of the sale. A second issue arises in the year in which the taxpayer sells only part of the stock. Taking into consideration the current tax rate and other capital gains and losses, the taxpayer can use specific identification to sell the lots that will maximize tax planning for the current year.
So the silver lining in possibly having missed the window for benefitting from the 100% Exclusion Provision is that it may have alerted you to the existence of Section 1202 and its possible benefits generally. A 50% or 75% haircut on capital gain, even if subject to AMT, should be welcome relief if you hadn't expected it in the first place. If you have any questions about whether you can benefit from Section 1202, please feel free to contact Peter T. Beach at pbeach@sheehan.com.
This article is intended to serve as a summary of the issues outlined herein. While it may include some general guidance, it is not intended as, nor is it a substitute for, legal advice. Your receipt of Good Company or any of its individual articles does not create an attorney-client relationship between you and Sheehan Phinney Bass + Green or the Sheehan Phinney Capitol Group. The opinions expressed in Good Company are those of the authors of the specific articles.
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