Entrepreneurs who launch successful new ventures, and the investors who fund these startup companies, can now really ring the economic bell upon a liquidity event, thanks to a recent change in the tax code.

An amendment to Section 1202 of the Internal Revenue Code (“IRC”), passed as part of the “Protecting Americans from Tax Hikes Act of 2015” (“PATH Act”), makes permanent the exclusion of 100% of the gain from the sale of qualified small business stock (“QSBS”) for stock acquired in 2015.

This exclusion existed prior to the passage of the PATH Act, but for non‑corporate taxpayers holding QSBS for more than five years, the exclusion percentage had varied, depending on when the stock was issued.

The PATH Act also makes permanent the exception for QSBS from alternative minimum tax preference treatment.

Gain from a QSBS sale is likewise excluded from the 3.5% Obamacare tax on net investment income.

Accordingly, IRC Section 1202 lets non‑corporate taxpayers realize substantial tax savings when selling QSBS stock held more than five years.

So how does stock qualify as QSBS? Section 1202 requires the following:

1. Such stock must be issued after August 10, 1993, in a C corporation (not an S corporation), meaning a condition of QSBS eligibility is that income or loss doesn’t pass through to shareholders;

2. As of the date the stock is issued, the corporation must be a domestic C corporation with total gross assets of $50 million or less at all times after August 9, 1993, and both before and immediately after such stock was issued (non‑cash assets being valued at the corporation’s adjusted basis);

3.  Generally, the stock must be acquired at its original issue, either in consideration for money or other property, or as compensation for services; and

 4. The corporation was a C corporation during substantially all the time a taxpayer held the stock.

Many startup companies initially elect to be S corporations so losses in the early years pass through to shareholders, as does income when the business turns profitable (avoiding a separate tax at the corporate level). Thus, the decision when a company is formed whether to elect S status must be carefully weighed against the potentially sizeable tax savings offered by Section 1202.

To qualify under the QSBS rules, at least 80% of a corporation’s assets must be used in the “active conduct” of one or more “qualified businesses.” Certain corporations, including foreign corporations, are ineligible under Section 1202. In addition, a variety of activities are, for QSBS purposes, excluded from the definition of a “qualified business.”

Excluded activities include:

·     Service businesses in the fields of health, law, engineering, architecture, accounting, actuarial services, performing arts, consulting, athletics, financial services or brokerage services.

·      A business whose principal asset is the reputation or skill of one or more employees.

·      A banking, insurance, financing, leasing, investing or similar business.

·      A farming business (including tree farming).

·      A business for which percentage depletion can be claimed, such as mining or natural resource production.

·     Operating a hotel, motel, restaurant or similar business.

For corporations in which a taxpayer sells or exchanges QSBS, the annual exclusion is, subject to a corporate per-issuer limitation, equal to the greater of:

a)     $10 million ($5 million for married persons filing separately) minus the cumulative amount of QSBS gain excluded by a taxpayer from sales of stock issued by that same corporation in earlier years; or

b)    10 times the taxpayer’s total adjusted basis in QSBS in the corporation disposed of in the tax year.

To illustrate how significant the tax savings can be, assume that Ivan Investor bought 100,000 shares of stock in Startup, Inc. on June 1, 2015, for $100,000, and that Startup, Inc. is a C corporation meeting the qualified business tests of IRC Section 1202. Ivan Investor has never owned QSBS until now.

In 2021 (after holding his Startup, Inc. shares for more than 5 years), Ivan Investor sells all of his stock for $20.1 million. His maximum gain exclusion from this sale in 2021 will be the greater of (a) $10 million; or (b) $1 million – i.e., 10 times his cash basis of $100,000 in this QSBS. So Ivan Investor gets to exclude $10 million of gain on this sale!

The $10 million balance of Ivan Investor’s $20 million gain – i.e., $20.1 million less $100,000 of basis – will be taxable at capital gain rates.

Note that the $10 million cap ($5 million for separate filers) is an aggregate limit on sales of QSBS in the same corporation. However, the 10x basis limit isn’t capped by a dollar amount; it is an annual limit.

This presents some planning opportunities if Ivan Investor’s stock sale can be structured over 2 years.

For example, assume Ivan Investor paid $5 million in 2015 for his 100,000 shares in Startup, Inc., giving him basis of $50 per share.

If Ivan subsequently sells 50,000 of his QSBS in Startup, Inc. in 2021 for $12.5 million, the entire $10 million gain ($12.5 million sales price less $2.5 million basis) would get excluded.

If Ivan then sells his remaining 50,000 shares in Startup, Inc. in 2022 for another $12.5 million, his $10 million profit in 2022 likewise gets excluded. That’s because the maximum eligible exclusion from gain for 2022 is the greater of (a) zero ($10 million less $10 million excluded in 2021); or (b) $25 million (10x Ivan Investor’s remaining basis of $2.5 million in the Startup, Inc. shares sold in 2022).

While the rule for QSBS and its benefits are complex, the potential tax savings can be considerable for entrepreneurs and investors funding qualified startup business ventures, provided they hold their QSBS for more than five years.

Having startup profits now being permanently eligible for up to 100% tax-free gain under IRC Section 1202 makes the QSBS exclusion a dependable and powerful tax planning tool – and who wouldn’t mind not paying taxes on a successful liquidity event?!

Michael R. Morris