United States: Exclusion For Small Business Capital Gains Made Permanent

Kevin M. Bergesen is an Associate in our Boston office.

What Happened?

While much has been written about the impact of The Protecting Americans from Tax Hikes (PATH) Act of 2015, which was signed into law on December 18, 2015, one short yet valuable provision has often been overlooked.1  Specifically, Section 126 of the PATH Act made permanent what is commonly known as Section 1202, which allows certain taxpayers to exclude 100% of capital gains associated with Qualified Small Business Stock (QSBS) from taxation.2

Who Does This Affect?

Congress intended to encourage long-term investment in startups and other small businesses by exempting capital gains in such entities from taxation.  The prior exclusion from such gain terminated at the end of 2014.  All entrepreneurs, founders, angel investors, and venture capitalists should pay careful attention to this exclusion – both during the entity formation process as well as when preparing for a liquidity event.

Does My Stock Qualify?

Individual and other non-corporate taxpayers may exclude 100% of capital gains upon the sale or exchange of QSBS, provided the following criteria are met by the Taxpayer and by the underlying Investment Entity in which the Taxpayer has invested:

Taxpayer Criteria

  • Taxpayer must not be a corporation
  • Taxpayer may hold the QSBS through an interest in a pass-through entity.  For example, a partner in a venture capital fund can qualify if the fund holds the QSBS. However, the Taxpayer must have held the interest in the entity on the same date the entity acquired the QSBS and until the earlier of the sale or other disposition.
  • Taxpayer must have acquired the QSBS after September 27, 2010
  • If the Taxpayer acquired the QSBS between August 10, 1993 and September 27, 2010, it is possible to qualify for a 50% or 75% exclusion, depending on the date of the QSBS acquisition
  • Taxpayer must have held the QSBS for more than five years
  • Taxpayer must have received the QSBS as an "original issuance," meaning when the company is formed, either directly, or through an underwriter

Investment Entity Criteria

  • The Investment Entity must be a C Corporation
  • Prior to and subsequent to the Taxpayer's investment, the Investment Entity's gross assets must never have exceeded $50 million
  • The Investment Entity must use 80% of its assets in active conduct of one or more active trades or businesses, (as distinguished from several non-qualifying businesses including a financial institution, farm, professional service firm, hotel, or restaurant)

Next Steps

There are important steps to take to ensure you qualify for the exclusion from capital gains.  The considerations vary depending upon the stage of your investment.  Are you an investor looking to deploy capital, an entrepreneur deciding how to structure your next entity, or did you make an investment in a small business after September 27, 2010?

Pre-Investment Planning

If the investment has yet to take place, it is advisable to consider Section 1202 in your choice of entity analysis.  Even if the entity was formed, but the investment not made, the investment can be restructured to take advantage of Section 1202. 
Consider obtaining a third-party valuation, both to establish the basis of your investment and to ensure the entity's assets are under the $50 million threshold. Investors should also be sure that the company founders are aware of the ongoing QSBS requirements, particularly the active business requirement and the limitation on real estate holdings.

For federal income tax purposes, a corporation may be either a "C corporation" or an "S corporation." The primary difference between a C corporation and an S corporation is that unlike with a C corporation, the income and loss of an S corporation flows through to the personal income tax returns of its shareholders, who pay income tax on net income at individual tax rates, and can deduct any net loss.

In order to obtain and maintain S corporation status, a corporation must meet strict requirements set forth under the Internal Revenue Code. For example, an S corporation may not have more than 100 shareholders, and all of the shareholders must be U.S. citizens or resident individuals, with certain exceptions.

Liquidity Event Planning

If you are considering exiting from an investment prior to the five-year holding period, there may still be ways to qualify for QSBS treatment, for example by use of a Section 351 exchange or a Section 368 reorganization.

If you are exiting after the five-year holding period, you should ensure that this QSBS treatment is well-documented during the sale or offering process, and you should work with your advisors to properly report your sale or exchange on Schedule D and Form 8949.

Footnotes

1 For a prior Holland & Knight LLP summary on the PATH Act, see https://www.hklaw.com/publications/Protecting-Americans-from-Tax-Hikes-Act-Makes-Substantial-Changes-to-Tax-Law-12-29-2015/

2 http://docs.house.gov/billsthisweek/20151214/121515.250_xml.pdf

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.

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