United States: A "PATH" To Substantial Tax Savings: Qualified Small Business Stock

Last Updated: June 16 2016
Article by Nicola Lemay, Earl W. Mellott and Abigail Wolf

In the early 1990s, Congress enacted the qualified small business stock ("QSBS") rules to incentivize equity investments in certain corporations. The QSBS rules reduce the effective federal income tax rate on the gain realized upon the sale of qualifying stock held by an eligible stockholder for more than 5 years. The maximum amount of gain that can be taken into account under the QSBS rules with respect to an eligible stockholder's stock in any single issuing corporation generally is the greater of $10 million or 10 times the stockholder's applicable tax basis in such stock.

The effective federal income tax rate applicable to gain that is subject to the QSBS rules has varied significantly over the years. Depending on its year of issuance, qualifying stock generally could be eligible for a 50%, 75% or 100% exclusion from federal income taxation. In late 2015, the Protecting Americans from Tax Hikes Act of 2015 (the "PATH Act") permanently extended the 100% exclusion from federal income taxation that previously had been in effect, including an exemption from the alternative minimum tax (still subject, however, to the preexisting "greater of $10 million or 10 times tax basis" limitation). The PATH Act's QSBS provision has a retroactive effective date. As a result, the 100% exclusion from federal income taxation applies to qualifying capital gains from the sale or exchange of QSBS acquired after September 27, 2010 and held for more than 5 years. For stock acquired on or before this date, the QSBS rules still may apply, but with the less favorable exclusion percentages and the application of an add-back to taxable income under the alternative minimum tax rules.

Since most states generally follow the federal rules for determining a taxpayer's taxable income, a sale or exchange of QSBS typically also can result in reduced state income taxation, with California currently being one exception.

Overview of QSBS Exclusion Percentages

The various applicable exclusion percentages (depending on the year of the QSBS's issuance), along with the resulting effective federal income tax rates, are summarized in the following chart:

Date QSBS Issued Exclusion QSBS
Effective Tax Rate
Non-QSBS
Effective Tax Rate
Aug. 11, 1993–
Feb. 17, 2009
50% 16.88% 23.8%
Feb. 18, 2009–
Sept. 27, 2010
75% 9.42% 23.8%
Sept. 28, 2010–
on
100% 0% 23.8%

In the case of the 50% and 75% Exclusion scenarios in the above chart, (i) the QSBS Effective Tax Rates take into account the special 28% tax rate under the QSBS rules (plus the 3.8% net investment income tax) applicable to the remaining 50% or 25% (respectively) of taxable QSBS gain, and (ii) the alternative minimum tax add-back applicable to the 50% or 75% of non-taxable QSBS gain.

The QSBS Effective Tax Rates do not apply to gain realized in excess of the "greater of $10 million or 10 times stock basis" limit, which excess is subject to tax under the regular non-QSBS rules. The Non-QSBS Effective Tax Rate in the above chart assumes a 20% long-term capital gain rate and additional net investment income tax of 3.8%.

Overview of QSBS Requirements

Even if stock was issued in a year in which the QSBS rules were in effect (whether at the 50%, 75% or 100% exclusion rates), numerous other requirements must be satisfied for a stockholder to qualify for the benefits of the QSBS rules. The following provides a general overview of the principal QSBS requirements. Note that special rules may apply in a number of circumstances that are not addressed in this summary (including, for example, rules relating to stock received in tax-free reorganizations or stock received by gift, death or distribution).

Eligible Stockholders; Holding Period Requirement

Only non-corporate stockholders, including individuals, estates and trusts, qualify for the benefits of the QSBS gain exclusion rules. A non-corporate investor that owns an interest in a flow-through entity partnership (including an LLC taxed as a partnership) also may be eligible for the exclusion with respect to such investor's share of the gain from the sale of QSBS held by the flow-through entity, provided that certain special rules are satisfied. An otherwise eligible stockholder also must have held the QSBS for more than 5 years to be eligible for the exclusion.

Qualified Small Business Stock

Stock generally is QSBS only if the stockholder acquired the stock at original issue from a domestic C corporation that is a qualified small business in exchange for money or property (other than stock) or as compensation for services to the corporation (other than as an underwriter).

Acquired at Original Issue Requirement

The tax benefits of the QSBS exclusion are available to stockholders (including service providers and founders) that acquire shares of stock from the issuing corporation. As previously described, the stock must be acquired from the corporation in exchange for money or property (other than stock) or as compensation for services (other than as an underwriter). For this purpose:

  • Conversion of debt; exercise of warrants or options into C corporation stock. The receipt of options, warrants, phantom stock rights or debt from a C corporation does not qualify as a receipt of stock for purposes of the QSBS rules. However, the conversion of debt into C corporation stock and the exercise of investor warrants or employee stock options are treated as acquisitions of stock at original issue.
  • Conversion of an LLC or partnership to a C corporation. If a partnership (including an LLC taxed as a partnership) is converted into a C corporation, C corporation stock issued in the conversion to members or partners of the LLC or partnership should be treated as the acquisition of stock at original issue if the conversion is appropriately structured. However, the QSBS rules would only apply to the portion of any gain that is attributable to appreciation in value of the C corporation stock that occurs after the conversion transaction.
  • Conversion of an S corporation to a C corporation. To be QSBS, the applicable shares must have been issued by an eligible domestic C corporation, not an S corporation. If an S corporation converts into a C corporation, the conversion will not cause shares that were issued by the S corporation to become eligible for QSBS treatment. However, shares of stock issued by the C corporation after this conversion may qualify as QSBS, provided that all the other QSBS requirements are satisfied with respect to such newly-issued shares.

Qualified Small Business Requirement

For stock to qualify as QSBS, the issuing corporation must be a qualified small business. For this purpose:

  • The issuer must be an eligible domestic C corporation at the time the stock is issued and during substantially all of the applicable stockholder's holding period for the C corporation shares being sold. Accordingly, shares issued by an S corporation would not satisfy this requirement. In addition, DISCs, RICs, REITs, REMICs, FASITs, cooperatives and certain other special types of corporations are not eligible corporations.
  • The aggregate gross assets of the issuer must not have exceeded $50 million at any time from inception up to the time immediately after the issuance. For this purpose, an issuer also shall be deemed to own a proportionate amount of the assets of its subsidiaries (as determined under the QSBS rules). The amount of an issuer's aggregate gross assets generally will be equal to the sum of the issuer's cash plus the aggregate adjusted tax basis of the other assets held (or deemed held) by the issuer, as determined under the QSBS rules; provided, however, that the tax basis of any property contributed to the issuer (immediately after such contribution) is deemed to be its fair market value at the time of the contribution.
  • The issuer must use at least 80% (by value) of its assets in the active conduct of one or more qualified trades or businesses during substantially all of the applicable stockholder's holding period. For this purpose:

    • Certain types of businesses are expressly excluded from being "qualified trades or businesses." For example, any trade or business involving the performance of services in the fields of health, law, engineering, consulting, financial services and many other types of service businesses will not qualify. In addition, hotel, restaurant, oil, gas, banking, investment, farming and certain other types of businesses will not qualify.
    • Research and start-up activities in connection with a future qualified trade or business generally may be treated as the active conduct of the qualified trade or business, regardless of whether these activities have generated any gross income.
    • In addition to assets clearly used in the active conduct of a qualified business, the following assets also may be counted as used in the active conduct of the business: (1) assets held for working capital needs; and (2) assets held for investment that are reasonably expected to be used within 2 years to finance research and experimentation in a qualified trade or business or to finance increases in the corporation's working capital needs. If a corporation has been in existence for at least 2 years, however, no more than 50% of the assets of the corporation will qualify as used in an active trade or business by reason of the rules described in (1) and (2).
    • A corporation shall be deemed to own a proportionate amount of the assets, and conduct a proportionate amount of the activities, of its subsidiaries (as determined under the QSBS rules).
    • There are limitations on the amount of portfolio stock and real estate that a corporation may hold and still be considered engaged in the active conduct of a qualified trade or business.
    • An otherwise eligible corporation that is licensed to operate as a "specialized small business investment company" (or SSBIC) under section 301(d) of the Small Business Investment Act of 1958 (as in effect on May 13, 1993) is deemed to satisfy the active business requirements.
  • The issuer must submit any reports that the IRS requires. Currently, the IRS has not created any reporting requirements for QSBS issuers.

Redemptions

In order to truly incentivize new investment in corporations, the QSBS rules provide that certain redemptions by the issuing corporation of its stock before or after the issuance of the corporation's stock may disqualify such stock from QSBS status.

More specifically, stock cannot be QSBS if, within two years before or after the issuance of such stock, the issuing corporation purchased any of its own stock from the taxpayer or from a person related to the taxpayer. Similarly, stock cannot be QSBS if, within one year before or after the issuance of such stock, the issuing corporation made one or more purchases of its stock with an aggregate value (as of the time of the respective purchases) exceeding five percent of the aggregate value of all of its stock as of one year before the issuance.

Purchase of Replacement QSBS

A stockholder may be able to defer the recognition of taxable gain from the sale of QSBS if replacement QSBS is acquired within 60 days from the date of the sale. Provided that the 60-day time limit (and other applicable requirements) are satisfied, a stockholder seeking this rollover treatment must make an election on or before the due date, including extensions, for filing the stockholder's tax return for the tax year in which the QSBS is sold. The rollover election, once made, can only be revoked with the written consent of the IRS, which requires the submission of a request for a private letter ruling.

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Events from this Firm
12 Oct 2018, Other, Boston, United States

The New England Electricity Restructuring Roundtable has been meeting bimonthly since 1995 to discuss current topics related to important changes in the electric power industry in Massachusetts and throughout New England.

Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions