With the recent introduction of the 3.8% Medicare tax and the increase in maximum long-term capital gains tax rates, investors might be feeling a little discouraged. Yet, not all is lost! As the Richard Welling team likes to say, “Every cloud has a tax-free lining – that may save you some silver.” If you have invested in small business stock since September 27, 2010 – or plan to invest before January 1, 2014 – you may qualify for a significant tax-free gain.
As part of the American Taxpayer Relief Act of 2012, Congress extended the ability for non-corporate taxpayers to exclude 100% of the gain on the sale of qualified small business stock (QSBS) held for more than five years, if acquired after September 27, 2010, and before January 1, 2014. If held for more than five years and acquired after February 17, 2009 and before September 28, 2010, taxpayers may still exclude 75% of the gain. In addition, there’s an alternative minimum tax (AMT) break – the excluded gain is counted as a non-preference item for AMT purposes.
To qualify as QSBS, stock must be of a C corporation (not an S corporation) that, since the time of the stock’s issuance, has gross assets of $50 million or less. For the most part, the taxpayer must have acquired the stock at the time of the original issuance. Furthermore, the business must be actively involved in the conduct of a qualified business for “substantially all” of the time the taxpayer has held the stock. A qualified business can be any business other than banking, farming, natural resources, hotels, restaurants, and certain services including healthcare, legal, engineering, architecture, accounting, and consulting.
The amount of gain eligible for the exclusion is the greater of (1) 10 times the taxpayer’s adjusted basis in the stock or (2) $10 million minus gain excluded during previous years.
For example:
John buys 20,000 shares of Qualified Small Business Stock (QSBS) in New Software Designs Inc. on November 1, 2013 at $5 per share, for a total cost of $100,000. He sells half his stock on November 2, 2019 for $10,000,000. The maximum gain eligible for exclusion is the greater of:
John will be able to exclude $10,000,000 of the total gain from the sale of the stock.
On December 14, 2020, the taxpayer sells the rest of the 5,000 shares for $500,000. The maximum gain eligible for exclusion is the greater of:
John will be able to exclude $500,000 of the total gain from the sale of the stock.
There’s no guarantee congress will extend this provision past the current 2013 deadline, so time may be of the essence. This provision of the tax code encourages investment in small businesses; you get to support the economy and potentially get rewarded with a tax break as well.
The complex QSBS requirements of Code Section 1202 go beyond what’s mentioned in this article, which is why it’s important to consult with a tax professional that understands the rules – as well as your personal situation. For a confidential, complimentary review of your tax situation please contact us today.
