Qualified small business stock: considerations for 100% gain exclusion.

• Author: Maldonado, Dominic

Beginning in 2015, for the first time since its enactment in 1993, Sec. 1202 allows noncorporate taxpayers to exclude from federal income tax 100% of the gain on the sale of certain qualified small business stock (QSBS), limited to the greater of $10 million or 10 times the adjusted basis of the investment. Unlike in prior years, this creates possible opportunities for noncorporate taxpayers who dispose of QSBS in a taxable transaction to potentially exclude the entire gain for federal tax purposes.

To qualify for the exclusion, five criteria generally must be met:

1. The stock must have been directly acquired via an original issuance from a U.S. C corporation (Sec. 1202(c) (1);

2. Both before and immediately after stock issuance, the C corporation's tax basis in gross assets did not exceed $50 million (Sec. 1202(d)(1));

3. The C corporation and shareholders must consent to supply documentation regarding QSBS (Sec. 1202(d) (1)(C));

4. The C corporation conducts certain qualified active trades or businesses (Sec. 1202(e)); and

5. The stock must have been held for more than five years (Sec. 1202(b)(2)).

Sec. 1202 was enacted with a 50% gain exclusion as part of the Omnibus Budget Reconciliation Act of 1993, RL. 103-66, based on a proposal from Sen. Dale Bumpers, D-Ark. Bumpers intended QSBS to apply to "all types of stock, including common, preferred and convertible preferred stock," and that a "[c] ompany may issue more than one round of qualified stock as long as the total aggregate capitalization does not exceed specified limits" (see generally 139 Cong. Rec. S1609 (Feb. 16, 1993)). This gives taxpayers significant flexibility in planning for potential QSBS treatment.

One may infer that Congress's intent in passing this legislation was to stimulate investment in small businesses and incentivize U.S. noncorporate taxpayers to invest in domestic corporate vehicles.

Why hasn't the QSBS Exclusion Been Used More in the Past?

The Small Business Jobs Act of 2010, P.L. 111-240, amended Sec. 1202 so that QSBS purchased after Sept. 27, 2010, and before Jan. 1, 2011, could potentially qualify for a 100% gain exclusion from federal regular income tax, alternative minimum tax (AMT), and the 3.8% net investment income tax under Sec. 1411. Subsequent "tax extender" legislation--including the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312; the American Taxpayer Relief Act of 2012, P.L. 112-240; and the Tax...