Paving the Way.

• Author: ALGER, REBECCA E.
• Position: Rules for qualifying small business stock

QUALIFYING SMALL BUSINESS STOCK RULES LEAD TO PLANNING OPPORTUNITIES

STOCK AN INCREASING NUMBER of your clients have it, and not too surprisingly they don't want to diminish their gains via taxes. For many, the answer might lay with the complex, yet financially favorable rules for qualifying small business stock (QSBS).

QSBS rules are relevant not just to founders of new businesses, but also to early stage employees, venture capitalists and investors. Many employee stock purchase plan shares, and exercised stock options also qualify under QSBS rules.

HOW IT STARTED

In 1993, the federal government enacted IRC Secs. 1202 and 1045 which provided for very special treatment of certain corporate stock acquired after Aug. 10, 1993. California followed with similar-but not identical-rules to allow for both exclusions and rollovers.

Stock that qualifies under Sec. 1202, when held for at least five years from the date of acquisition, is eligible for a 50 percent exclusion from capital gains taxes up to a cumulative value of $10 million (or, if greater, 10 times the basis of the stock sold). The federally taxed portion is subject to a 28 percent capital gains rate, while an add back under the alternative minimum tax computation, results in a fairly nominal total tax savings on a full $10 million. In contrast, California tax savings are significant. On a full exclusion of $10 million of qualifying gain, the savings can exceed $900,000.

Both IRO Sec. 1045 and California Revenue and Taxation Code Sec. 18038.5 allow for a rollover (deferral of gain) on any QSBS stock that is held for six months or more from the date of acquisition. This provides for the gain's rollover if new QSBS is acquired within 60 days after the sale of the original stock. The advantage of the rollover provisions, particularly when the underlying qualifying stock is highly volatile, cannot be over emphasized. Rather than risking even a one-year hold to qualify for long-term gain treatment, the stock can be held for as little as six months, and the proceeds reinvested in new qualifying stock within 60 days, with no immediate tax paid on the transaction.

For a summary of highlights of the major provisions under IRC Secs. 1202 and 1045 as well as R&TC Secs. 18038.4, 18038.5, 18151, 18152, 18152.5 and 18155.5, see sidebar, Page 23.

ELECTIONS AND REPORTING REQUIREMENTS

The election to roll over under IRC Sec. 1045 and R&TC Sec. 18038.5 may be made on either a timely filed original return or on an amendment of an open year. The election is made on Schedule D, with the gain on sale reported on one line, followed immediately with a line reporting IRC Sec. 1045 (and R&TC Sec. 18038.5) rollover, and the amount of the deferred gain shown as a negative number.

The exclusion of gain under IRC Sec. 1202 (and R&TC Sec. 18038.5) is also made on Schedule D. The gain on the sale is reported, followed immediately with a line showing the excluded amount as a negative number, and the description "Sec. 1202 gain excluded." Since the taxable portion is taxed, for federal purposes, at 28 percent, the net taxable gain should be included in Column (g).

The portion of the gain excluded under Sec. 1202 from capital gains taxation must be included on...