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Excluding Gain on Qualified Small Business Stock – What to Know to Qualify

Did you know that you could sell the stock of your company and potentially exclude up to 100 percent of the gain from taxable income? Under Section 1202, the gain on the sale of qualified small business (QSB) stock held for five years is partially or entirely excluded from income.

  • Fifty percent of the gain is excluded for stock acquired between August 10, 1993 and February 18, 2009,
  • Seventy-five percent gain is excluded from stock acquired between February 18, 2009 and September 27, 2010,
  • 100 percent of the gain is excluded for stock acquired after September 27, 2010. The 100 percent exclusion is permanent.

What are the requirements to hold QSB stock?

  1. C Corporation – on the date of issuance, the issuing corporation must be a domestic C Corporation.
  2. Qualified Small Business – on the date the corporation issues its stock, the corporation must meet two tests for its gross assets test.
    1. At all times, through the date of issuance, the aggregate gross assets of the corporation must not have exceeded $50 million. Once the corporation’s gross assets exceed $50 million, the corporation can no longer issue QSB stock.
    2. Immediately after the date of issuance (after taking into account amounts the corporation received in the issuance), the aggregate gross assets of the corporation must not exceed $50 million
    3. Example – X Co. issues stock to A in 2006 when its gross assets are $20 million. In 2012 and 2014, X Co. issues stock to B and C, respectively, when its aggregate gross assets are $30 million and $45 million. In 2018, X Co. issues stock to D and immediately after the issuance X Co.’s aggregate gross assets are $52 million. The fact that X Co.’s gross assets exceed $50 million in 2018 does not taint the stock of X Co. previously issued to A, B, and C. It does mean the stock issued to D cannot qualify as QSB stock and that no future issuance of X Co. stock will qualify as QSB stock even if the gross assets drop below the $50 million threshold.
    4. Aggregate gross assets – the amount of cash the corporation holds plus the aggregate adjusted basis of other property the corporation holds. Because this test looks to the basis of the corporation’s assets, rather than the value, a corporation could have substantial self-created intangible value (such as goodwill) without exceeding the $50 million threshold. For purposes of Section 1202, the adjusted basis of any property contributed to the corporation is equal to its fair market value on the date of contribution. This prevents shareholders from circumventing the $50 million threshold by contributing low basis/high value property to a corporation in exchange for QSB stock.
  3. Original Issue – QSB stock must be acquired at original issuance directly from the issuing corporation in exchange for money or other property or as compensation for services provided to the corporation. A shareholder who acquires stock from an existing shareholder will not be treated as having received the stock at original issuance. When stock is received as a gift, at death or as a distribution from a partnership, the stock is treated as having been received by the transferee in the same manner as the transferor.
  4. Substantially All Test – the corporation must be a C Corporation on the date of issuance and during substantially all of the shareholder’s holding period.
  5. Active Business Requirement – at least 80 percent of the corporation’s assets (fair market value) must be used by the corporation in the active conduct of the trade or business.
    1. If the corporation owns at least 50 percent of the stock in a subsidiary corporation, the corporation is deemed to own its ratable share of the subsidiary’s assets and liabilities. The corporation will fail the 80 percent tests if more than 10 percent of the value of its net assets consists of stock or securities in corporations that are not at least 50 percent owned by the parent corporation.
    2. A corporation will fail the 80 percent test if more than 10 percent of the total value of its assets consists of real property that is not used in the active conduct of a qualified trade or business. The owning or renting of real property is not treated as the active conduct of a trade or business.
      1. Working capital – a reasonable amount of working capital may be included in the 80 percent test, however, after two years of operations, only 50 percent of the corporation’s assets can be from working capital to meet the 80 percent test. This rule is for a corporation that is successful in raising equity funds after a couple years of operations. In such case, the corporation could have a substantial amount of cash on hand of which only 50 percent can be counted toward the 80 percent test.

Can I exclude my gain on an asset sale?

No, Section 1202 only allows for an exclusion of the gain on sale or exchange of QSB stock. If a C Corporation sells its assets rather than its stock, the Section 1202 exclusion will not be available. If the corporation subsequently liquidates by distributing the sales proceeds to its shareholders, the shareholders should be able to use Section 1202 to exclude any gain upon liquidation.

Can I terminate my S Corporation election to take advantage of the gain exclusion?

The answer is yes and no. Since QSB stock must be issued by a C Corporation on the date of issuance, stock in a S Corporation can never qualify as QSB stock even if the S Corporation later converts to a C Corporation. If the S Corporation terminates its election, it would need to issue new shares of QSB stock meeting all the requirements detailed above. The Section 1202 exclusion would then only apply to the QSB stock if held for at least five years. The gain on the stock that was previously an S Corporation would not qualify for the exclusion.

Holding QSB stock can provide tremendous tax savings by excluding up to 100 percent of the capital gain on sale from taxable income. The requirements for investing in QSB stock can prove to be very complicated so it is important to consult your tax advisor to assure you will qualify for the gain exclusion after the five-year holding period.