Excluding and rolling over gain on disposition of qualified small business stock.

• Author: Ellentuck, Albert B.

SEC. 1202 ALLOWS NONCORPORATE TAXPAYERS to exclude from gross income 50% of any gain from the sale or exchange of qualified small business stock (QSBS) acquired before Feb. 18, 2009, or after Dec. 31, 2011, and held for more than five years. This provision applies to stock issued after Aug. 10, 1993. The 50% capital gain exclusion removes some of the double taxation that applies to C corporation stock ownership if the fairly restrictive requirements can be met. The major impediments are limits on the size of the business, types of eligible businesses, and types of assets a corporation can have and still meet the definition of a qualified small business. In addition, S corporation shareholders qualify for the gain exclusion only if they held their interest in the S corporation when the QSBS stock was acquired and at all times until the stock was disposed of.

Although the maximum tax rate on an individual's net long-term capital gain was 15% for 2012, a 28% capital gains rate applies to the sale of the QSBS after the 50% reduction in gain from the sale. Therefore, the effective regular tax rate for a sale of QSBS is 14% (28% x 50%). However, 7% of the excluded gain is an alternative minimum tax (AMT) preference item under Sec. 57(a)(7). If the entire preference is subject to the 28% AMT rate, the effective rate on the gain for taxpayers subject to AMT is 14.98% ([50% + (50% x 7%)] x 28%). Thus, the QSBS exclusion provided little benefit through the end of 2012. However, taxpayers (other than C corporations) who realize a gain from the disposition of QSBS held more than six months can elect under Sec. 1045 to roll over their gain to the extent they acquire replacement QSBS during the 60-day period beginning on the date of the sale. Gain is recognized to the extent the sales proceeds exceed the cost of replacement stock.

Beginning in 2013, the regular long-term capital gain rate returned to 20% (barring any last-minute changes by Congress) so the difference between the two rates is 6% (20% regular long-term capital gain rate versus 14% effective rate under Sec. 1202). Thus, it makes sense to meet the QSBS requirements when possible, since the stock may be sold when capital gains are taxed at a higher rate than 15%. Also, the ability under Sec. 1045 to roll over gains on QSBS to replacement stock remains an advantage.

Example 1: H Inc. issues QSBS to its shareholders. H has a marginal corporate tax rate of 34%. Its taxable income minus the...