Qualified Small Business Stock Exception
Using the Qualified Small Business Stock Exception (QSBS) allows you to claim the gain on stock held by a qualified small business. However, there are some guidelines to follow in order to claim the gain. In this article, we will discuss some of the key points to consider.
Options for claiming Section 1202’s gain exclusion
Founders and investors of businesses have several options for claiming Section 1202’s gain exclusion for qualified small business stock. Qualified small business stock (QSBS) is a type of non-corporate stock that can be held in a number of structures, including partnerships, LLCs, and S corporations. However, before claiming Section 1202 gain exclusion for QSBS, it is important to understand the qualifying requirements and restrictions. These rules may affect your decision to sell QSBS, as well as your options for later capital raises.
First, to be eligible for Section 1202 gain exclusion, a corporation must meet two gross-assets tests. The 80% Test determines whether 80% of the corporation’s assets are used in a qualified trade or business. This test excludes assets that are used for non-qualifying activities and cash that is not required for working capital needs. It also includes the value of all tangible and intangible assets, including the company’s un-booked goodwill.
Second, stockholders must meet the holding period requirement. Stockholders must hold QSBS for at least five years before they can claim Section 1202 gain exclusion. When a stockholder’s holding period expires, they have the option to sell the QSBS in a taxable sale or reorganize under Section 368 tax-free reorganization. However, if a taxpayer does not satisfy the five-year holding period requirement, they can choose to sell the QSBS in a non-recognition exchange. This exchange can be conducted under Rule 144. However, it is not always advisable for taxpayers to sell QSBS.
A stockholder can also elect to recognize gain as though the QSBS were sold at fair market value, instead of at the original issue price. This is a good option for taxpayers who hold QSBS in non-grantor trusts, but are concerned about the taxation of gains that occur during this period. In this case, the taxpayer can reorganize under Section 368 tax-free restructuring, or take advantage of the Section 1202 gain exclusion.
Another option is to exercise incentive stock options (ISOs). This is one of the options for claiming Section 1202’s QSBS gain exclusion. ISOs are stock options that are granted to shareholders of a qualified small business. However, the stockholder must decide when to exercise the ISOs, which can expose the holder to an AMT tax if the stock is not sold during the ISO’s five-year holding period. This option can be beneficial for stockholders, as it allows them to extend their holding period to take advantage of long-term tax exemptions.
In addition to exercising ISOs, stockholders have a number of other options for claiming Section 1202’s tax benefits. For example, investors can take advantage of the $10 million gain exclusion cap, but taxpayers who paid cash can have their gain exclusion cap surpassed. Additionally, taxpayers may be eligible for gain exclusion over a $10 million cap if they contributed property to their corporation during the year.
Recapitalizations and restructurings affect QSBS status
Generally, stock acquired during a recapitalization or restructuring will qualify as QSBS, though there are certain rules that must be met in order to qualify. In addition, there is a built-in Section 1202 gain rule that applies to exchanges of QSBS for other QSBS. This rule is intended to allow QSBS to retain QSBS status despite a restructuring or recapitalization. It applies only to gain that would have been taxed if the stock was not exchanged in a tax-free reorganization.
For a recapitalization to qualify, the assets of the corporation and any subsidiaries must not exceed $50 million. In addition, the assets must be used in a qualified active business. The assets may be used to provide compensation, services, or property. The holder of QSBS must also hold the stock for five years. After five years, the stock must be sold. Upon distribution to partners or members, QSBS retains QSBS status. In addition, the stock must be acquired directly from the issuing corporation.
If a recapitalization fails the $50 million gross assets test, the corporation still qualifies as a tax-free “E” reorganization. This is because the recapitalization may qualify under Section 1202(h)(4), which allows QSBS to qualify for gain exclusion in tax-free recapitalizations. In this case, the recapitalization may also qualify as a tax-free reorganization under Section 368(a)(1)(E), which is also a tax-free recapitalization. The recapitalization may also qualify under Section 1202(h)(4) if the assets are used to satisfy the qualified small business tests.
Unlike “E” reorganizations, a recapitalization that fails the $50 million gross assets test does not qualify for gain exclusion under Section 1202(h). This is because Section 1202(h)(4) allows QSBS to qualify for gain exclusion only in a tax-free reorganization. It does not affect QSBS status in a restructuring. However, the recapitalization may still qualify under Section 1202(h)(3).
Another possible solution is to issue additional stock to non-QSBS stockholders. However, if the issuing corporation fails the $50 million gross assets test, the stock will not qualify for gain exclusion under Section 1202(h)(4). The stock must also be acquired for money or property. This can be achieved through a reverse stock split, which splits the stock into more than one share of stock of the same corporation. The issuing corporation must file an amendment to its articles of incorporation to complete the stock split. This can also be achieved through a stock distribution with respect to outstanding stock.
In addition, a recapitalization that fails the Section 1202(h)(3) or 1202(h)(4) tests may still qualify for a tax-free “E” rorganization. The recapitalization may also qualify under another Section 1202(h) rule, which allows a corporation to exchange QSBS for other QSBS in a tax-free reorganization. The issuing corporation must meet the $50 million gross assets test and must issue QSBS for money or property. It is also important to note that the holding period rules for stock exchanged during a recapitalization add the holding period of the original stock to the holding period of the stock issued in the recapitalization.