Is the qualified small business stock exclusion worthwhile.

• Author: Cohen, Ann Burstein
• Position: Taxation

When enacted in 1993, Sec. 1202 seemed like a bargain--exclusion of 50% of the capital gain realized on the sale or exchange of qualified small business stock held for more than five years. However, with recent legislation's decrease in the capital gains rates and more taxpayers than ever subject to the alternative minimum tax, the exclusion is no longer the deal it seemed to be. This article explains why.

On Aug. 12,1998, the Sec. 1202 exclusion of 50% of the gain on qualifying small business (QSB) stock finally became fully operational. Sec. 1202 was added by Section 13113(e) of the Revenue Reconciliation Act of 1993 (RRA '93), effective for QSB stock issued after Aug. 10, 1993.

Sec. 1202's purpose is to encourage the investment in small, start-up companies that traditionally have difficulty raising capital. The incentive is provided to noncorporate shareholders who purchase QSB stock originally issued after Aug. 10, 1993 and hold it for more than five years. What are the actual tax savings provided Sec. 1202? This article demonstrates that a taxpayer does not save 50% of the tax liability; in some circumstances, he may even be worse off with the Sec. 1202 exclusion.

Overview

Sec 1202 places numerous and complex requirements on both the QSB and the shareholder. Under Sec. 1202(d)(1), the QSB's gross assets cannot exceed $50 million immediately after the stock issuance. Other restrictions apply throughout the holding period of the stock, including the following:

* The nature of the business (generally, not professional services, financial, farming, insurance, mineral extraction, restaurants or lodging), under Sec. 1202(e)(3).

* The percentage of assets (generally, at least 80% by value) devoted to the active conduct of the business, under Sec. 1202(e)(1)(A).

* The percentage of assets invested in other corporations (10% or less, unless they are more-than-50%-owned subsidiaries), under Sec. 1202(e)(5)(B).

* The redemption of stock, under Sec. 1202(c)(3).

Other restrictions, including the ability of a passthrough entity to hold the stock (Sec. 1202(g)) and shareholder transfer prohibitions (Sec. 1202(h)), apply at the shareholder level.(1)

Under Sec. 1202(a), if all of the requirements are met and the stock is held for more than five years, the noncorporate shareholder can exclude 50% of the sale gain from taxation. Sec, 1202(b) provides that the maximum gain subject to the exclusion is the greater of $10 million (on a cumulative basis) or 10 times the shareholder's adjusted basis. While this exclusion sounds very enticing, on closer examination, it is not as valuable as it first appeared in 1993. The diminution of the benefit is caused by two factors--changes in the capital gains rates since the RRA '93 and the alternative minimum tax (AMT).

At the time the RRA '93 was passed, the maximum long-term capital gains rate for individuals was 28%; the AMT was raised by that legislation to its current rate of 26% on the first $175,000 of AMT base and 28% on the excess. Section 311(a) of the Taxpayer Relief Act of 1997 (TRA '97) lowered the maximum long-term capital gains rate to 20% for both regular tax and AMT purposes, but not, according to Sec. 1(h)(4)(C) as amended, for Sec. 1202 stock. Thus, the taxable portion of the Sec. 1202 gain continues to be taxed at 28%. Further, for most stock purchased after 2000 and held for more than five years, the 20% rate drops to 18%; this rate will not apply to gains from Sec. 1202 stock, which will continue to be taxed at 28%. Apparently, Congress believes that QSB shareholders are already deriving significant benefits through the 50% exclusion and do not need a further rate reduction. The IRS Restructuring and Reform Act of 1998 (IRSRRA '98), Section 5001(a)(1), lowered the maximum capital gains rate for midterm gains (gains on capital assets held more than 12 months but not more than 18 months) from 28% to 20%; the 28% rate continues to apply to Sec. 1202 stock. The decreases in the capital gains rates on other, less risky investments has reduced the Sec. 1202 advantage, as is later shown.

The AMT Explosion

A further erosion of the Sec. 1202 benefit is caused by the AMT. RRA '93 Section 13113(e) made 50% of the QSB exclusion an AMT preference. Under TRA '97 Section 311(b)(2)(B), the AMT preference was lowered to 42% of the exclusion (i.e., 21% of the total gain). IRSRRA '98 Section 6005(d)(3) lowered the AMT preference to 28% of the exclusion for QSB stock acquired after 2000. As has been widely reported of late, AMT is affecting increasing numbers of individual taxpayers, due in part to the lack of indexing of various AMT factors. A recent Joint Committee on Taxation report(2) indicated that while only 140,000 individual returns reported AMT in 1987, 856,000 will in...