As the economy picks up to yield-reduced investment risk, and as an increase in tax rates continues to threaten, the benefits of Section 1202 qualified small-business stock deserve some attention. From both the perspective of the investor seeking to maximize after-tax yields and the entrepreneur seeking additional capital, the 2010 Tax Relief Act's extension of the 100 percent exclusion of gain from Section 1202 stock for an additional year, through Dec. 31, 2011, is an opportunity worth revisiting. What remains constant under any second look, however, is that Section 1202 requires patience: It will take a taxpayer at least five years to see how the story ends after any particular acquisition of qualified stock.
As Section 1202 now exists, the 100 percent exclusion of gain from the sale or exchange of qualified small-business stock by a non-corporate taxpayer applies to qualified small-business stock acquired after Sept. 27, 2010, and before Jan. 1, 2012, and held for more than five years. While the Obama Administration's FY 2012 budget proposes making the 100 percent rate permanent, most insiders don't see this happening at this time. Given that prediction, less than seven months remain until Dec. 31, 2011, rolls around and presents a likely last chance to acquire stock that will qualify for the 100 percent rate.
PERCENTAGE OF GAIN EXCLUDED
To encourage investment in small businesses and specialized small-business investment companies, Code Sec. 1202(a) allows a taxpayer (other than a corporation) to exclude from gross income a certain percentage of the gain realized from the sale or exchange of qualified small-business stock held for more than five years. That percentage depends upon the date that stock is acquired:
For stock acquired after Sept. 27, 2010, and before Jan. 1, 2012, a 100 percent exclusion applies.
For stock acquired after Feb. 17, 2009, and before Sept. 28, 2010, a 75 percent exclusion applies.
For stock acquired before Feb. 18, 2009, or after Dec. 31, 2011, a 50 percent exclusion generally applies (for stock issued by a corporation in an empowerment zone, a 60 percent exclusion applies, except to gain attributable to periods after Dec. 31, 2014).
For purposes of the 50, 60 or 75 percent exclusion, gain excluded under the small-business stock provision is not used in computing the taxpayer's long-term capital gain or loss, and it is not investment income for purposes of the investment interest limitation. As a result, the taxable portion of the gain is taxed at present at a maximum rate of 28 percent under Code Section 1(h). That twist, of course, is not an issue when 100 percent of the gain is excluded under Section 1202.
Unlike the 50, 60 or 75 percent exclusion, too, the 100 percent exclusion is unique in allowing it to apply for both regular and Alternative Minimum Tax purposes. Under the lower exclusions, a portion of the excluded gain is subject to AMT.
GROSS ASSETS TEST
A qualified small-business corporation's aggregate gross assets cannot exceed $50 million either before the issuance of the stock or immediately thereafter. Immediately after the issue date, the $50 million cap must take into account any amounts received for the stock on its issuance. If at any time before the issuance, but on or after Aug. 10, 1993, the corporation or any predecessor held gross assets exceeding $50 million, the stock will not qualify.
Gross assets for purposes of the $50 million cap include cash plus the aggregate adjusted bases of all other corporate property. Adjusted basis for this purpose is determined as if the basis immediately after the contribution were equal to the property's fair market value on the contribution date.
Although qualification of issued stock is not dependent upon keeping under the $50 million asset ceiling subsequent to its issuance, the test will disqualify any subsequently issued stock once the $50 million ceiling is reached. For businesses close to the $50 million mark looking to issue further qualified stock, managing cash flow and expenses should become a priority. This might especially be the case in certain research and development operations that realize significantly greater expenses than income over an extended period of time.
80 percent assets test. In addition to the 50 percent gross assets test, the issuing corporation must pass an active business requirement during substantially all of the taxpayer's holding period for that taxpayer to qualify for the exclusion. That test is passed if during that period at least 80 percent of the assets (by value) of the corporation are used in the active conduct of one or more qualified trades or businesses. Code Section 1202(e)(3) provides a non-exclusive list of trades or businesses that are not qualified, including service businesses in health, law, architecture, accounting, and financial services. The list is relatively long and should be consulted during due diligence.
Burden of proof. Code Sec. 1202(d)(1)(C) requires the corporation to submit reports to the IRS and shareholders "as required by the secretary" to carry out the purposes of the gross assets test. Failure to make the reports does not result in disqualification, but a penalty of either $50 or $100 per report is imposed based on the degree of negligence. To date, the IRS has failed to specify any requirements.
Irrespective of a penalty, it is the shareholder's burden to prove qualification for the exclusion. Going back to corporate records after five years may prove expensive, if not difficult, to undertake. Proving continuing qualification under the active business requirement presents another challenge. Shareholders counting on the exclusion, and corporations wanting to promote it, are advised to marshal their proof at the time of issuance and keep it in a safe place. The IRS will not give advance rulings on this issue.
PER-ISSUER LIMITATION
On the investor side of Section 1202, shareholders should be aware of their own limit on the amount of gain that is eligible for the exclusion. There is a cumulative limit on the gain from any one issuer that a taxpayer may take into account, based on either a dollar amount or the taxpayer's basis in his qualified stock as of the issue date. Under the per-issuer rule, a taxpayer may hold qualified stock in more than one corporation and apply the limit separately to each; investments in separate, multiple corporations, therefore, are encouraged.
A taxpayer's eligible gain from the disposition of qualified stock of any single issuer is subject to a cumulative limit for any given tax year equal to the greater of:
1. $10 million ($5 million for married taxpayers filing separately), reduced by the total amount of eligible gain taken in prior tax years); or,
2. Ten times the taxpayer's adjusted basis in all qualified stock disposed of during the tax year.
The "10 times" alternative can be quite significant when applied together with the rule that allows a fair-market-value basis for contributed property other than cash or stock. It effectively enables all appreciation of that asset since issuance to be covered by the 100 percent exclusion, up to 10 times its value irrespective of the dollar amount.
The interaction between the lifetime $10 million limit and the 10-times annual limit has raised some questions. Issues involve whether the cumulative $10 million cap can ever pose an absolute limit, and whether the sale of separately acquired blocks of qualifying stock may be netted. In connection with netting a low-basis block of stock with a high-basis block to maximize the 10-times limit, the consensus is that it works if the sale takes place all in one tax year, but that it may not if blocks are sold in different years. Although these issues as they are raised in connection with the 100 percent exclusion for calendar-year taxpayers will not first arise until late 2015 based on a five-year holding period, practitioners are hoping for an answer from the IRS a bit sooner.
OTHER RESTRICTIONS
To be eligible for the exclusion, the taxpayer must acquire the small-business stock at its original issue (directly or through an underwriter), for money, property other than stock, or as compensation for services provided to the corporation. Small-business stock does not include stock that has been the subject of certain redemptions that are more than de minimis. However, stock acquired through the conversion of stock (such as preferred stock) that was qualified stock in the taxpayer's hands is also qualified stock in the taxpayer's hands.
For taxpayers uncomfortable with being locked into a particular small-business investment for five years without losing the benefit of the gain exclusion, a Section 1045 rollover might present a solution. A taxpayer other than a corporation that realizes gain from the sale of qualified small-business stock held for more than six months may elect to defer recognition of that gain, other than gain treated as ordinary income, to the extent that the taxpayer buys qualified small-business stock within the 60 days beginning on the date of the sale. Coordination of a rollover with the requirements to maintain Section 1202 status and to the degree to which it is retained carries its own special rules.
A taxpayer who holds qualified stock as a gift or inheritance steps into the shoes of the transferor with respect to both acquisition and holding period. A partnership may distribute qualified stock to its partners so long as the partner held the partnership interest when the stock was acquired, and only to the extent that the partner's share in the partnership has not increased since the stock was acquired.
When qualified stock is issued in exchange for property other than money or stock, the stock is treated as having a basis at least equal to the property's fair market value, and as having been acquired on the date of the exchange. If the basis of qualified stock is later adjusted by reason of the holder's contributions to the corporation's capital, the contributed property's basis is treated as being at least equal to its fair market value at that time. This rule ensures that only gains accruing after the transfer are eligible for the exclusion.
ANOTHER 5-YEAR HOLDING PERIOD
Another rate reduction to reward a long-term holding period of more than five years is potentially available after 2012. The sunset after 2012 of the capital gains provisions of the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), as extended for 2010 and 2011 by the 2010 Tax Relief Act, brings with it the reinstatement of the lower capital gain tax rates that had been available during the 2001-2003 period for "qualified five-year gain." The lower rates - 8 percent for taxpayers in a 10 percent or 15 percent income tax bracket, and 18 percent for taxpayers in higher brackets - apply to capital gain on assets held for more than five years.
The reinstatement of the 8 percent and 18 percent capital gain rate on assets held for more than five years, while technically the law after 2012, clearly will be contingent on the outcome of the larger debate over whether to increase tax rates. At best, these rates at present should be considered as a possible backstop to stock that may fail a Section 1202 test. A major difference between the two five-year holding periods, therefore, is that the Sec. 1202 gain exclusion is guaranteed once the stock qualifies and the five-year holding period is met. The disposition of non-Sec. 1202 stock held for more than five years, on the other hand, is not guaranteed a reduced capital gain rate due to the uncertain future of tax rates in general.
CONCLUSION
The 100 percent exclusion of gain on the disposition of qualified small-business stock remains in the law as currently written for stock acquired until the end of this year. After Dec. 31, 2011, the exclusion rate drops in half to 50 percent. Although first enacted and then extended during a period during which the economy was viewed as much worse than predictions now indicate, the tax incentive to invest in certain types of small businesses remains at the same high, 100 percent exclusion level for the time being. Section 1202 qualified small-business stock is worth investigating while this window of opportunity remains open until the end of the year.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a Wolters Kluwer business.
