Under IRC Section 1202, noncorporate taxpayers generally may exclude 100% of their gain (subject to a per-issuer limitation) from the sale or exchange of qualified small business (“QSB”) stock if the QSB stock is acquired after September 27, 2010 and has been held for more than five years.
Qualified Small Business Eligibility
Stock of a corporation is QSB stock if the following requirements are met:
- “C” Corporation. The stock must be issued by a domestic “C” corporation after August 10, 1993.
- Original Issuance. The taxpayer must have acquired the QSB stock at original issue (including through an underwriter) in exchange for money or property other than stock or for services.
- Gross Assets Test. The corporation’s gross assets must be $50 million or less both before and immediately after the stock is issued.
- Stock can continue to be QSB stock if the corporation’s assets exceed $50 million after the issuance of the stock; however, once the $50 million threshold has been exceeded, the corporation will not be permitted to again issue stock that will qualify as QSB stock.
- The determination of gross assets is generally determined by reference to the amount of cash and the adjusted tax basis of other property (fair market value in the case of contributed property).
- Active Business Requirement. At least 80% of the corporation’s assets (based on value) must be used in the active conduct of one or more “qualified trades or businesses.”
- Qualified trades or business are any trades or businesses other than specified business engaged in providing services (e.g., health, law and those relying on the reputation or skill of employees), finance, farming, certain natural resource production or extraction or a lodging or restaurant business.
- Five-Year Holding Period. In order to qualify for the exclusion, the taxpayer must hold the QSB stock for more than five years.
- Stock Owned by Partnership or S Corporation. Stock owned by a pass-through entity qualifies as QSB stock to an individual owner of the pass-through if:
- The amount is attributable to gain on the sale or exchange by the pass-through entity of stock that is QSB stock in the hands of the pass-thru entity (determined by treating the pass-through entity as an individual);
- The pass-through entity held the stock for more than five years; and
- The amount is includible in the taxpayer’s gross income by reason of the holding of an interest in the pass-through entity that was held by the taxpayer on the date on which the pass-through entity acquired the stock and at all times thereafter before the disposition of the stock by the pass-through entity.
- Redemption Rules. Certain redemptions of a taxpayer’s stock by the corporation can cause the taxpayer’s stock to not qualify as QSB stock. The rules are more restrictive if there is a “significant redemption” of more than 5% of the QSB’s stock (by value) during a specified period.
- Per-Issuer Limitation. Taxpayers can only exclude a specified amount of gain with respect to the QSB stock of a single issuer. The gain limitation is the greater of:
- Ten times the taxpayer’s aggregate adjusted tax basis in the QSB stock of that issuer disposed by the taxpayer during the taxable year, or
- Ten million dollars (reduced by the aggregate amount of the gain taken into account by the taxpayer under Section 1202 with respect to that issuer in any prior year).
For example, a person acquired 1,000 shares of QSB stock on July 15, 2015, at a total cost of $100,000. They then sell all their shares in 2023 for $20 million, and the per-issuer limitation is the greater of: (1) $1 million, i.e., 10 times X’s $100,000 total basis in the 100 shares, or (2) $10 million. Since they acquired the QSB stock after Sept. 28, 2010, the 100 percent exclusion applies. On their 2023 return, they can exclude $10 million of the $20 million gain realized on the disposition. Any gain in excess of the $10 million limitation would be taxed as capital gain.
Contact your Varnum attorney with any questions.