Since its enactment in 1993, Section 1202 of the Internal Revenue Code has provided non-corporate investors with the ability to exclude from federal taxable income up to 50% of the gain realized from the sale of "qualified small business stock" (QSB Stock) held for more than five years. Although venture capital financings and other investments in small businesses are often structured with this in mind, the strict and somewhat complex requirements and limitations of Section 1202 often made the exclusion elusive.

Legislation passed in 2009 and 2010, however, made the exclusion (and the ability to roll over gain to other QSB Stock under Section 1045) much more attractive for 2011. Capital financings and investments made (or gain from the sale of QSB Stock rolled over and invested in new QSB Stock) before the end of this year will reap significant tax benefits. Here we provide you with a brief overview of Section 1202 and the tax benefits available under the current exclusion rates, which expire on December 31, 2011.

Now and Then: Exclusion Rates Under Section 1202

Prior to 2009, Section 1202 provided an exclusion from federal taxable income for 50% of any gain realized from the sale of QSB Stock, but the seemingly generous 50% exclusion was limited in several ways:

  • The amount of gain eligible for the exclusion was limited to the greater of (1) $10,000,000, reduced by the amount of gain attributable to the issuer's stock already excluded by the investor in prior tax years, and (2) 10 times the aggregate adjusted basis of all of the issuer's QSB Stock disposed of by the investor during the current tax year.
  • Long-term gain from the sale of QSB Stock ineligible for the exclusion was subject to taxation at a maximum rate of 28% (and not the lower rate of 15% currently in effect for most other types of assets).
  • A portion of the gain excluded under Section 1202 was required to be included in income for alternative minimum tax (AMT) purposes.

Example 1: Investment in QSB Stock Acquired Prior to 2009

Investor acquires QSB Stock on October 1, 2006, and sells it on November 1, 2011, realizing a gain of $100,000. Provided all the requirements of Section 1202 are met, Investor can exclude $50,000 from federal taxable income but is taxed at a rate of 28% on the remaining $50,000 and pays $14,000 in taxes. Investor's effective tax rate is 14%. If Investor is also subject to the AMT, 7% of the excluded $50,000 is treated as an item of tax preference, and Investor's effective tax rate climbs to over 14.9%.

Although the cap on the gain eligible for the exclusion remains in effect, legislation passed in the last two years provides for exclusion rates of 50%, 75% or 100%, depending on when the QSB Stock is acquired. In addition, for QSB Stock acquired between September 28, 2010, and December 31, 2011, no portion of the excluded gain is includable in income for AMT purposes.

Example 2: Investment in QSB Stock Acquired in 2011

Investor acquires QSB Stock on February 1, 2011, and sells it on March 1, 2016, realizing a gain of $100,000. Provided all the requirements of Section 1202 are met, Investor can exclude all $100,000 from federal taxable income and no portion of the excluded gain is includable in income for AMT purposes.

The recent legislative amendments to Section 1202 expire at the end of this year, at which point the pre-2009 rules will once again apply. Therefore, investment in QSB Stock is only tax-exempt (up to the amount of gain eligible for the exclusion) in 2011. The following table summarizes the rules and the periods during which they are applicable:

Practice Tip

Investors routinely require representations in stock purchase agreements that assist them in determining whether the issuer's stock will in fact qualify as QSB Stock at the time of investment, as well as covenants in investor rights agreements to ensure the issuer's continuing commitment to complying with the requirements of Section 1202. The content of those representations and covenants often needs to be negotiated due to the uncertain nature of some of the Section 1202 requirements, as described below.

What is QSB Stock?

Generally, stock will be treated as QSB Stock only if all of the following requirements are satisfied:

  • The QSB Requirement. The issuer is required to have been a "qualified small business" (QSB) as of the date of issuance. That is, the issuer was a domestic C corporation and neither it nor any predecessor corporation had aggregate gross assets in excess of $50 million at any time prior to or immediately after the issuance of the stock in question. For purposes of Section 1202, gross assets generally include the corporation's cash and the aggregate adjusted tax basis of any other property (including intellectual property) held by the corporation.
  • The Active Business Requirement. The most onerous of the QSB Stock requirements stipulates that, during substantially all of the investor's holding period, the issuer must have used at least 80% (by value) of its assets in the active conduct of one or more "qualified trades or businesses." For this purpose:
    • A "qualified trade or business" is any trade or business except those explicitly identified by the statute. Businesses that are not considered qualified trades or businesses include consulting, health or legal services; financial and brokerage services (or any other business where the issuer's principal asset is the reputatiomendn or skill of one or more of its employees); banking, insurance, farming and certain mining businesses; and any business operating a hotel, motel, restaurant or similar business.

Practice Tip

The natural evolution of a startup company's business from, for example, the development, production and sale of a product to the provision of customized products or consulting services can make this requirement difficult to satisfy for "substantially all of the investor's holding period."
  • Special tax-advantaged entities (such as domestic international sales corporations, regulated investment companies and real estate investment trusts) cannot satisfy the active business requirement.
  • Generally, assets used in certain startup activities, research and experimental activities or in-house research activities may be treated as used in the active conduct of a qualified trade or business.
  • For corporations that have been in existence for less than two years, any assets that are held to meet the reasonable working capital needs of a qualified trade or business, or that are held for investment and are reasonably expected to be used within two years to finance research and experimentation or increase a qualified trade or business's working capital, are treated as used in the active conduct of such business. For corporations that have been in existence for two years or more, only 50% of those assets will qualify to be counted as used in the active conduct of a trade or business.

Practice Tip

Given the limitation on the amount of working capital (or assets held to meet future working capital or research and experimentation needs) that can be counted toward satisfaction of the active business requirement, QSB Stock representations and covenants required by investors may be more difficult for a company to provide once it has been in existence for two years or more.
    • A corporation does not meet the active trade or business test for any period during which (1) more than 10% of the total value of its assets consists of real property not used in the active conduct of a trade or business, or (2) more than 10% of the value of its assets (in excess of liabilities) consists of stock or securities in other corporations (excluding stock of the corporation's subsidiaries and stock held for investment and reasonably expected to be used to finance research or experimentation, or to increase the corporation's working capital needs within two years).
  • The Original Issuance Requirement. Stock is required to have been acquired by the investor at its original issuance (directly or through an underwriter) in exchange for cash or property (other than stock), or as compensation for services (other than as an underwriter of the stock). To this end, and subject to limited exceptions, stock acquired by an investor will generally not be treated as QSB Stock if either (1) at any time during the four-year period beginning two years before the issuance of the stock, the issuer redeems any of its stock from the investor or a related person, or (2) at any time during the two-year period beginning one year before the issuance of the stock, the issuer redeems stock with an aggregate value exceeding 5% of the aggregate value of all of its stock as of the beginning of the two-year period.

Rolling Over QSB Stock Gain

Section 1045 of the Internal Revenue Code allows non-corporate investors to defer gain from the sale of QSB Stock held for more than six months if other QSB Stock is purchased within 60 days of the date of sale. Provided Section 1045's requirements are met, gain on the sale of the original QSB Stock is recognized only to the extent that the amount realized exceeds the replacement stock's purchase price. To the extent gain is not recognized, that amount is applied to reduce the investor's basis in the replacement stock. In addition, the holding period of the original QSB Stock is tacked to the holding period of the replacement stock.

Example 3: Rolling Over Gain from the Sale of QSB Stock in 2011

Investor acquires QSB Stock on October 1, 2006, for $100,000 and sells it on March 1, 2011, for $200,000. On April 15, 2011, Investor acquires new QSB Stock for $200,000. Provided the Section 1045 requirements are met, Investor does not recognize any gain on the sale of the original QSB Stock but takes a basis in the replacement QSB Stock of $100,000. The appreciation in the replacement QSB Stock is now subject to the 100% exclusion rate, rather than the 50% exclusion rate applicable to the QSB Stock purchased in 2006. In addition, because the holding periods are tacked, Investor could sell the replacement QSB Stock as soon as six months later and take advantage of the 100% exclusion rate at that time. (Contrast this with the treatment of the same Investor who did not roll over gain from the sale of previously held QSB Stock, in Example 1 above.)

The recent legislative changes to Section 1202 offer particularly significant tax benefits to investors who choose—by the end of 2011—to invest in QSB Stock or roll over gain from QSB Stock previously held. Due to the complexity of the provision, investors and issuers should consult with their tax advisors regarding their specific circumstances prior to seeking the benefits of Section 1202.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.