[IMGCAP(1)]While it has been around in a variety of forms since 1993, the exclusion for Qualified Small Business Stock Gains under section 1202 of the Tax Code didn’t really come into its own as a tax benefit until the exclusion rate increased to 100 percent in 2010.
Even with the increase in the exclusion rate, it was not a viable inducement for investors to fund startups due to the fact that it was one of the “extenders” that were periodically reenacted, sometimes retroactively, according to CohnReznick’s Dave Logan and Asael Meir. All that changed with the passage of the PATH Act (the Protecting Americans from Tax Hikes Act of 2015), last year’s extenders bill, which made the exclusion permanent.
“Now, founders and investors can plan their investment activities with this in mind,” said Logan. “Until now, the vehicle they have typically used is convertible debt.”
“Historically, in early stages investors would come in with formal convertible debt,” said Meir. “It takes the form of a loan to the company with the right to convert it into stock at a discount. If investors hold convertible debt for four years and then converts it, they won’t be able take advantage of the exclusion, but if they bought it as stock from day one and sell it more than five years later, it will meet one of the qualifications for the exclusion. It’s important to be in equity from day one.”
One example, according to Meir, is an investor who comes in with $10 million as convertible debt. “Five years later the company sells, and the investor will receive $100 million. The investor will be taxed on the capital gain at a 25 percent rate. But in the same scenario— except that from day one the investor put in $10 million for stock and sells for $100 million—potentially, the whole $100 million is excluded.”
In order to qualify for the exclusion, the stock has to be Qualified Small Business Stock, and it has to be held for more than five years, Logan noted.
“The company has to be a C corporation, and the stock has to be acquired by the taxpayer at original issue, and at all times prior and including the transaction when the acquisition takes place the gross assets of the corporation have to be $50 million or less,” he said. “That includes the transaction, so when you acquire the stock, that funding is included. It can grow afterwards, but at the date of the acquisition, the assets have to be $50 million or less, including the amount contributed.”
“Not any stock works—it has to be qualified small business stock,” Logan said. “At least 80 percent of a corporation’s assets must be used in the active conduct of one or more qualified businesses. It can’t be a service organization, such as an accounting firm, or a law firm relying on members’ expertise to provide to clients. It has to be held for more than five years, and the entity that owns the stock must be a non-corporate owner. There’s a special rule for partnerships, but it is limited to what happens afterwards. If you’re in a partnership and the partnership buys stock, it can qualify, but the exclusion would not work for any new partner.”
When first forming the entity, care should be taken as to the form the financing takes, he observed. “Equity should be considered versus other forms because of the potential exclusion. On exit planning, make sure it is the stock that is being sold for value, as opposed to selling the assets in the C corporation.”
“If I own a software company and sell the code, I pay tax on it as an asset sale, but if I sell the stock in the corporation it can qualify for the exclusion,” Meir said. “There are companies out there where the investor is unaware that they may qualify. This provision has been under the radar, so it’s important to advise your clients that may have such holdings to see if the stock would qualify. If they sell it after four and one-half years, they won’t get the exclusion, but if they hold it for an additional half-year they could possibly exclude all their gain.”
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