Capital gain exclusion on small business stock.

• Author: Smith, Patrick J.

One of the more intriguing provisions of the Small Business Jobs Act of 2010, P.L. 110-240 (the Jobs Act), is the 100% exclusion from gross income of capital gains from the sale of certain qualified small business stock (QSBS). Generally this provision will allow taxpayers to pay no federal tax on up to $10 million in gain from the sale of certain QSBS. As originally enacted, the provision required taxpayers to have acquired the QSBS after September 27, 2010, and before January 1, 2011, but the latter date was promptly extended for one more year, to January 1, 2012, by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2011, P.L. 111-312.

The Sec. 1202 capital gain exclusion for QSBS has been in existence since 1993. Generally, the amount excluded from gross income was 50% of eligible gains, although the excluded portion was increased to 75% for stock issued in 2009 and most of 2010. The includible portion of the gains was generally taxed at a 28% capital gains rate. Furthermore, an amount equal to 7% of the amount excluded from gross income was a preference for alternative minimum tax (AMT) purposes, which had the effect of increasing alternative minimum taxable income (Sec. 57(a)(7)). Because of the increased tax rate on the portion not excluded from gross income and the AMT preference, most taxpayers enjoyed very little or no federal benefit for the Sec. 1202 exclusion. Some taxpayers did enjoy some state tax benefit from the exclusion. For example, California taxpayers typically experienced reduced California taxes as a result.

With this recent change, however, taxpayers in general will be able to exclude up to $10 million in gain from gross income with no preference for AMT purposes. Clearly, the provision was designed to encourage the formation of small businesses prior to year end with the goal of creating new jobs. To be eligible for the exclusion, the taxpayer must hold the QSBS for more than five years. Thus, the earliest one can benefit from the 100% exclusion would be 2015.

Qualification for Sec. 1202 Exclusion

For QSBS to qualify for the 100% exclusion, all the limitations applicable to investments in qualified small businesses must be met, including the following:

* The QSBS must be acquired after September 27, 2010, and before January 1, 2012.

* The QSBS must be held for more than five years (subject to certain exceptions for qualifying tax-free rollovers).

* The exclusion applies only to...