The capital gains exclusion from Section 1202 Qualified Small Business Stock (QSBS) and Section 1202 has recently gained popularity as a tax-saving strategy. Section 1202 has been around for almost 30 years when it was enacted in 1993, however, over the years it has been amended to adjust the portion of the total capital gain that can be excluded. Shares acquired from August 11, 1993 to February 17, 2009 qualify for a 50% exclusion. Shares acquired from February 18, 2009 to September 27, 2010 qualify for a 75% capital gains exclusion, and shares acquired from September 28, 2010 to present qualify for a 100% capital gains exclusion. There is also no longer an alternative minimum tax preference for qualifying shares acquired on or after September 28, 2010.
The earnings exclusion is limited to the greater of $10 million OR 10 times the overall adjusted QSBS investment base. The earnings exclusion limits apply on a shareholder-by-shareholder basis. This allows for planning potential to maximize benefits.
In general, the following criteria must be met to benefit from the exclusion:
- Shares must be directly acquired by initial issue of a domestic C corporation
- Company C’s total gross assets did not exceed $50 million, before and immediately after the stock issue
- At least 80% of qualifying small business assets are used in the active conduct of at least one “qualifying trade or business” as defined
- The title must be held for more than five years
The shares acquired must be at the initial issue and acquired in exchange for cash, services or goods (other than shares). The shares must be issued directly by the company and not received from a third party (as in the case of a secondary offer).
It should be emphasized that the corporation issuing the shares must be a C corporation. There are special and complicated rules regarding potential conversions of LLCs and S corporations to C corporation status. Your tax advisor should be contacted in this regard. In addition, it should be noted that a sale of assets of Company C before the five-year holding requirement could certainly prove to be tax-expensive.
The term “qualifying trade or business” is generally defined by exclusion. Those not eligible include many professional services, performing arts, consulting, athletics, financial services, brokerage services, banking services, insurance, financing, leasing, investment, agriculture, hotels, restaurants, or any trade or business where the main asset of that trade or business is the reputation or skill of one or more of its employees. Qualifying the trade or business is one of the most critical aspects of planning.
There has been little published guidance as to whether a particular trade, business or activity is deemed to be a qualifying trade or business. There is certainly a bias against service industries. Second. 199A (Qualified Business Income Deduction) cross references Sec. 1202 when discussing a qualified trade or business for its purposes. Although certainly not necessarily binding, Sec. Regulations 199A can, at least, provide some level of guidance regarding their analysis of what trade or business activities are considered qualified.
Takeovers, reorganizations and recapitalizations may impede the ability to qualify for IRC 1202. Each scenario should be analyzed to determine whether the company and the shareholder meet all the requirements of IRC 1202. In addition , Company C and the shareholder must be able to properly document that QSBS eligibility has reasonably been achieved. Therefore, early planning is highly recommended.
Further analysis should be considered with respect to state and local tax jurisdictions, as they may have been severed from this earnings exclusion.
The following common questions we have encountered regarding 1202 scheduling:
Q: What happens if the five-year hold period is not met, but the stock meets all other qualifications for QSBS?
A: IRC section 1045 generally allows rolling of QSBS gains.
The stock must be held for more than six months and less than five years.
The taxpayer must purchase new QSBS shares within sixty days of the sale of the original QSBS shares and make an election on their tax return.
Q: Is this a $10 million lifetime exclusion for all QSBS transactions?
A: No, it’s per share issuer, so investments in multiple companies may qualify for multiple exclusions.
Q: Do a husband and wife each have a $10 million exclusion per issuer?
A: There is ambiguity in this area and this should be discussed further with your tax advisor. But we note that there are many tax professionals who believe the position that each spouse could benefit from their separate $10 million exclusion on a joint tax return for married couples is supported.
Q: What happens if my partnership distributes QSBS shares to me rather than selling them within the partnership?
A: The share is deemed to be owned by the partner who received the partnership share, and it is still an original share assuming the partner was a partner at the time of acquisition initial.
Q: What type of estate planning and gifts is available?
A: If the owner of the QSBS shares dies, the beneficiary is deemed to own the originally issued shares. The value of the shares is included in the taxable estate of the owner.
Shares can be given either outright or in an irrevocable trust and continue to be originally issued shares.
When the shares are given away, the new owner now has their own exclusion of $10 million. This can be a powerful technique regarding gifts to children and other family members.
It is best to give away the stock when it has a low valuation, closer to buying and therefore, for best use of the lifetime gift exclusion.
Using power of override and then disabling the licensor’s trust status is another technique to transfer QSBS.
Please note that donations to trusts that have the same creator and the same beneficiary may be treated as the same trust.
A Grantor Retained Annuity Trust (GRAT) is a vehicle used to deliver QSBS. The GRAT should be in place years before any potential sale of QSBS. This will allow for lower valuations. The key is that after the GRAT term ends, the shares transferred to beneficiaries are no longer included on the taxpayer’s tax return and now have new lifetime exclusions of $10 million.
Income tax proposals should be carefully monitored for potential impact on Sec. 1202 profit exclusion.
Taxpayers should discuss all QSBS investments they have made with their advisers when they are made so that the advisers can advise them properly. With proper planning, substantial capital gains can be excluded from income tax. Additionally, advisors can help taxpayers transfer assets to future generations with little estate or gift tax.
HOW CITRIN COOPERMAN CAN HELP YOU
Citrin Cooperman is ready and able to help you navigate new tax saving strategies. To learn more about Qualified Small Business Stock (QSBS) and the Section 1202 capital gains exclusion, please contact Heather Oboda at [email protected]
ABOUT THE AUTHOR
Heather Oboda is a tax partner with over two decades of experience in public accounting. Specializing in trusts and estates, Heather offers tax, financial, estate and estate planning services. She specializes in coordinating the filings of family groups, including their private entities, trusts and foundations, in addition to their personal filings. His clients include trusts and estates, high net worth individuals and their closely held businesses. She is an active member of the firm’s Trusts and Estates practice.
ABOUT CITRIN COOPERMAN
“Citrin Cooperman” is the brand under which Citrin Cooperman & Company, LLP, a licensed independent CPA firm, and Citrin Cooperman Advisors LLC serve the business needs of clients. The two firms operate as separate legal entities in an alternate practice structure. Citrin Cooperman is one of the nation’s largest professional services firms. Clients span all industries and take advantage of a comprehensive menu of service offerings. Entities include over 200 partners and over 1,500 employees across the United States