In response to the economic crisis that occurred starting in late 2007, Congress has enacted a number of measures intended to spur investment and business activity. The purpose of this article is to explore one of those incentive provisions, which would allow an investor to effectively pay zero (0%) capital gains tax in connection with certain assets provided that the investment occurs during 2011. This is as a result of temporary changes in Section 1202 of the tax code enacted in December 2010. Section 1202 of the code relates to investment in “qualified small business stock” (QSBS). To qualify for this incentive the stock must not only be a “qualified small business”, but the stock also has to be held for at least five years before being sold.
History of Section 1202
Section 1202 was originally enacted in 1993, but its benefits were quite limited until recently. Prior to 2009, 50% of the gain from the sale of QSBS could be excluded. However, the capital gains rate applicable to QSBS was 28%, not the 15% rate that has applied to most investment assets since 2003. This resulted in an effective rate of 14% compared to a 15% tax rate on corporate stock that was not QSBS. Thus, the QSBS exclusion provided little incentive to taxpayers in the years leading up to 2009. Under the American Recovery and Reinvestment Act of 2009 enacted early in the Obama administration, the exclusion was increased to 75% for stock acquired after February 17, 2009 and before January 1, 2011, resulting in an effective federal tax rate of 7%. Then in September of 2010 with the enactment of the Small Business Jobs Act of 2010 (“2010 SBJA”) the exclusion was increased to 100% for purchases of qualified small business stock after September 27, 2010 and on or before December 31, 2010. A 100% exclusion of gain equates to a 0% capital gains rate. The 2010 TRA prevented this provision from expiring on December 31, 2010 and extended it to purchases of QSBS occurring on or before December 31, 2011. In addition to providing a 0% capital gains rate, the 2010 TRA also provides that the excluded gain will not be treated as an item of tax preference for AMT purposes.
Definition of QSBS
Only stock in a “small business” is eligible for the exclusion. The corporation must not have more than $50 million in gross assets at the time stock was issued or any time on or after August 10, 1993 (that’s the date Section 1202 was first enacted) through the date of issuance. Generally, the amount of gross assets equals the amount of cash and aggregate adjusted tax basis of other property. This is significant as adjusted tax basis may be significantly below fair market value. In addition, the corporation must have been engaged in the active conduct of a qualified trade or business during substantially all of the taxpayer’s holding period for the stock. Generally, to qualify, a corporation must use at least 80% of its assets in the active conduct of one or more qualified businesses, which generally excludes investment companies, professional services and consulting, banking, insurance and other financial services, farming, oil & gas or mineral extraction, and the hotel, motel or restaurant business.
The following are some additional qualifications:
- The corporation must be a C corporation, i.e., it cannot be a corporation that has elected to be taxed as an S corporation.
- The corporation must be formed in the US and certain entities with special tax status are not eligible (e.g., REITs, REMIC, regulated investment companies and cooperatives).
- The stock must be issued for money or other property (not including stock) or as compensation for services provided to the corporation (other than underwriter services).
Limitation on Gain Eligible for Reduced Taxation
The amount of gain eligible for Section 1202 treatment is limited to the greater of $10 million (for married taxpayers filing jointly) reduced by gain on the same issuer’s stock already excluded in prior tax years, or 10 times the taxpayer’s basis in the stock disposed of during the taxable year. The exclusion is per issuer, so that a taxpayer can potentially hold investments in more than one company that qualifies as a “qualified small business” and exclude up to $10 million on each investment (or 10 times basis, if greater). It is important to understand the $10 million amount is the amount of gain eligible for Section 1202 treatment. For QSBS acquired in 2011 that means that $10,000,000 of gain can be effectively excluded from tax completely, but only $5,000,000 of gain can be excluded on QSBS acquired prior to the recent tax incentives. That is because previously a taxpayer with $10,000,000 of gain from QSBS was allowed to exclude 50% of the eligible gain, or $5,000,000.
Investors Who Can Benefit From Section 1202
The Section 1202 exclusion clearly applies to entrepreneurs setting up a new business venture, as well as existing C corporations that are in need of additional equity capital. In addition, stock acquired in connection with the conversion of an existing loan to a QSBS should also be eligible for Section 1202 treatment. Finally, owners of existing LLCs, partnerships and sole proprietorships can take advantage of Section 1202 and can benefit from the 0% capital gains rate by converting the LLC, partnership or sole proprietorship to a C corporation in 2011. Only the gain that accrues after conversion will be eligible for the 0% capital gains rate. Stated differently, gain that already existed at the time of conversion is not eligible for the exclusion:
Example: the sole owner of a business contributes the assets of the business to a qualified small business corporation in exchange for QSBS. At the time of contribution the tax basis of the assets was $100,000 but the value was $1,000,000. Six years later the QSBS is sold for $5,000,000. The owner would be able to exclude the $4,000,000 in appreciation that occurred after the contribution, and would not be able to exclude the $900,000 in gain that existed at the time of contribution.
The benefits of Section 1202 can be claimed by individual investors, LLCs, partnerships, S corporations and certain other pass-through entities. However, the exclusion of gain under Section 1202 will only be achieved if the exit is a sale of stock. If the actual exit is an asset sale by the C corporation, then there will be tax at the corporate level on any gain resulting from the acquisition. This would result in a tax outcome that is no better than what could be achieved with an LLC or S corporation, and possibly a worse outcome.
The gain from the sale of Section 1202 stock can also be rolled over (i.e., the tax can be deferred) under Section 1045 of the Code. To be eligible, the QSBS must have been held for at least six months and the taxpayer must reinvest the proceeds of sale in stock of another qualified small business corporation during a 60-day roll-over period. Note that it is not necessary to hold QSBS for 5 years in order to qualify for a roll-over.
California – Similar but Different
Gain from the sale of QSBS may also be taxed at a reduced rate for California income tax purposes. Section 18152.5 of the Revenue & Taxation Code provides for a 50% exclusion of gain for QSBS. California law generally provides for the taxation of capital gains at the same rate as ordinary income, so the effect of this provision is to provide for the taxation of gain on QSBS at 50% of the taxpayer’s marginal rate. California’s QSBS provision contains additional limitations designed to restrict eligibility to corporations whose business activities are heavily concentrated in California. This provision has existed for many years, and California has not taken any action to increase the exclusion percentage to conform to the changes in federal law.
It is very important that a conversion transaction be structured carefully with Section 1202 eligibility rules in mind. The incorporation of an existing LLC or partnership can be structured in several different ways, and not all of these structures will allow the owners to qualify for Section 1202 treatment. Of course, there are a number of factors other than Section 1202 to consider when deciding whether to form a C corporation for a new business or to convert an existing proprietorship, LLC or partnership to a C corporation. Also, care must also be taken to avoid triggering a tax event by incorporating. While the incorporation of an existing business is usually tax free under Section 351 of the tax code, there are circumstances where an incorporation transaction will be wholly or partially taxable.
In the right circumstances Section 1202 might offer interesting opportunities for investors and business owners. The ability to achieve 0% capital gains tax for investments or conversions in 2011 may be attractive, especially to those who may, as a result of other planning considerations, already be contemplating additional capital contributions, debt conversions or the conversion of an existing LLC, partnership or sole proprietorship to C corporation status. Of course, taxpayers need to recognize that the benefits of Section 1202 will not be realized unless the stock is held for five years and that the exit is a stock sale. The roll-over benefit under Section 1045 would be available for stock sales prior to the end of the five-year holding period, but again the exit from the QSBS would have to take the form of a stock sale. Anyone wishing to take advantage of the 0% capital gains rate under 2010 TRA needs to act promptly as this incentive expires at the end of 2011.
George S. Cabot is a tax attorney (State Bar certified specialist) in Walnut Creek, with a practice emphasizing entity level tax planning and general business matters. Contact him at 925-979-3312 or firstname.lastname@example.org.
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