I. Executive Summary
This article provides general information regarding U.S. federal income tax incentives available to non-corporate holders of “qualified small business stock” (“QSB stock”) as defined under Section 1202 of the Internal Revenue Code.1
In general, under current law, Section 1202 allows a non-corporate taxpayer to potentially exclude up to 100% of the amount of eligible gain realized from the sale or exchange of QSB stock held for more than five years.
The amount of gain that is eligible for exclusion by a taxpayer with respect to QSB stock held in a particular corporation is subject to an annual limitation equal to the greater of either:
(i) $10 million (reduced by the aggregate amount of eligible gain taken into account by the taxpayer in prior taxable years with respect to dispositions of QSB stock of such corporation); or
(ii) 10 times the aggregate adjusted bases of QSB stock issued by such corporation and disposed of by the taxpayer during the taxable year.
In addition, Section 1045 allows a taxpayer to potentially roll-over gain from the sale of QSB stock that has been held for more than 6 months.
A. General Benefits and Eligibility
1. Potential 100% Exclusion for Stock Acquired After September 27, 2010
Section 1202 was originally enacted as part of the Omnibus Revenue Reconciliation Act of 1993 in order to encourage investments in small businesses.2
Pursuant to Section 1202(a)(4), the exclusion percentage for newly issued QSB stock is currently 100%, coupled with a corresponding 100% exclusion for alternative minimum tax (“AMT”) purposes. Excluded gains under Section 1202(a)(1) are also not subject to the 3.8% Medicare tax imposed under Section 1411.3
Historically, Section 1202 provided for other exclusion percentages (in general, 50% or 75%), depending on when a taxpayer’s QSB stock was issued and the type of business conducted by the issuing corporation.4 In addition, the excluded portion of a taxpayer’s eligible gain was treated as a preference item that had to be added back to a taxpayer’s taxable income for AMT purposes (in general, typically subject to a 7% add-back under Section 57(a)(7) and a maximum rate of 28%). The amount of a taxpayer’s eligible gain that was not excluded under Section 1202(a)(1) was also generally subject to tax at a 28% rate (which was higher than otherwise prevailing capital gains rates).5
For additional details regarding the historic exclusion percentages, and resulting effective tax rates, that applied to QSB stock issued under old law (prior to September 28, 2010), see Part VI.A of this article.
2. Stock Held by a Non-Corporate Taxpayer In a Qualifying C-Corp.
In general, in order to qualify for the benefits of Section 1202 a non-corporate taxpayer must acquire and hold stock in a qualifying C-corporation. The benefits of Section 1202 do not directly apply to equity interests acquired and held in pass-through entities, such as S-corporations or partnerships. However, as discussed in more detail later in Part II.B.9 of this article, an individual taxpayer’s allocable share of gain attributable to a sale of QSB stock by a pass-through entity may potentially qualify as gain eligible for the Section 1202 exclusion.
B. Overview of Requirements
There are four main requirements that must be satisfied before gain on the sale of stock is potentially eligible for the exclusion under Section 1202. Each of these requirements is briefly mentioned immediately below and then discussed in more detail in Parts II through V of this article.
1. Stock of a C-Corporation Acquired at “Original Issuance”
Sections 1202(c)(1) (lead-in language) and (c)(1)(B) generally state that QSB stock means any stock held with respect to a C-corporation that is originally issued after the date of the enactment of the Revenue Reconciliation Act of 1993, if such stock is acquired by the taxpayer at “original issue” (directly or through an underwriter) in exchange for money or other property (not including stock), or as compensation for services performed for such corporation (other than services performed as an underwriter of such stock).
2. Qualified Small Business Requirement
Sections 1202(c)(1) (lead-in language) and (c)(1)(A) also generally require that as of the date of issuance the issuing corporation must be a “qualified small business.”
3. Active Business Requirement
In general, pursuant to Section 1202(c)(2)(A), stock in a corporation shall not be treated as QSB stock unless, during substantially all of the taxpayer’s holding period, such corporation meets the “active business requirements” of Section 1202(e) and such corporation is a C-corporation. Pursuant to Section 1202(c)(2)(B), this requirement is waived for certain specialized small business investment companies that are licensed to operate under Section 301(d) of the Small Business Investment Act of 1958 (as in effect on May 13, 1993).
4. Five-Year Holding Period
Section 1202(b)(2) effectively requires that QSB stock must be held for more than five years in order for the amount of any gain realized from the sale or exchange of such stock to be eligible for the exclusion under Section 1202.
