Tax-Free Gains on Qualified Small Business Stock

A brief time window remains for certain new businesses to be organized as a C corporation for which gain realized on the future sale of stock will be exempt from income tax.  A 100% exclusion applies to Qualified Small Business Stock (QSBS) acquired by noncorporate taxpayers during the period of September 28, 2010 through December 31, 2011.  After 2011 the exclusion drops to 50%.  Also, for QSBS acquired after 2011, an alternative minimum tax preference applies to a portion of the excluded gain.  Furthermore, a 28% Federal capital gain tax rate (instead of the usual 15% maximum rate) applies to unexcluded QSBS capital gains after 2011.  The opportunity to exclude capital gains from income tax also applies to purchases of QSBS from existing corporations that meet the requirement.  Some of the basic requirements are the following:

1. The purchase must be of original issue (after August 10, 1993) stock from the corporation in exchange for money, property contributed to the corporation, or services rendered to the corporation,
2. The corporation must be a domestic C corporation and it may not make the S election,
3. Immediately after the stock is issued, and at all times after August 9, 1993 and before the stock is issued, the corporation's total gross assets are and were $50 million or less, and
4. At least 80% of the value of the corporation's assets were used in the active conduct of one or more qualified businesses.

A qualified business is one that is NOT:

1. A service business in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services,
2. A business whose principal asset is the reputation or skill of one or more employees,
3. A banking, insurance, financing, leasing, investing, or similar business,
4. A farming business,
5. A business whose products are eligible for percentage depletion, or
6. A hotel, motel, restaurant, or similar business.

To be eligible for the gain exclusion, the QSBS must have been held for more than 5 years.  In addition, there is a limitation on how much gain can be excluded.  The limitation is the greater of:

1. A lifetime limit of $10 million of gain from the sale of QSBS in the same corporation ($5 million if married filing separately), or
2. Ten times the taxpayer's total adjusted basis in the QSBS sold.

While the tax benefits of investing in QSBS are significant, so are the rules that must be met to qualify.  If you have the opportunity of investing in or establishing a qualified small business, due diligence must be performed in order to ascertain whether the tax rules have been met before you make the investment.