Pay No Federal Tax on Qualified Small Business Stock

Qualified Small Business Corporations (QSBCs) are a special category of corporation, the stock of which can potentially qualify for three different gain exclusion breaks. The hot news is that QSBC shares issued between now and December 31, 2013 are eligible for a 100 percent federal gain exclusion break if you hold shares for more than five years before selling.

The Definition of a QSBC

The following requirements must be satisfied for a corporation to be a QSBC.

  • It must be a domestic C corporation. It cannot be: an S corporation or a foreign corporation; a DISC or former DISC; a Section 936 corporation or a corporation with a Section 936 subsidiary; a regulated investment company; a real estate investment trust; a real estate mortgage investment conduit; or a cooperative.
  • The corporation must also satisfy an active business requirement. The requirement is satisfied if at least 80 percent (by value) of the corporation’s assets are used in the active conduct of a qualified business. Qualified businesses generally do not include service businesses; banking, insurance, leasing, financing, investing, or similar activities; farming (including raising/ harvesting timber); production or extraction of oil, natural gas, or other natural resources for which percentage depletion deductions are allowed; or the operation of a hotel, motel, restaurant, or similar business.
  • The corporation’s gross assets cannot exceed $50 million: (1) at all times on or after August 10, 1993 and before the stock was issued and (2) immediately after the stock was issued.

In addition, to be eligible for the QSBC gain exclusion breaks, the stock must meet requirements set forth in Section 1202 of the Internal Revenue Code.

Here are the basics about tax-favored QSBC stock, which is covered under Internal Revenue Code Section 1202.

General 50 Percent Gain Exclusion Rule

Under the general gain exclusion rule, QSBC shareholders (other than C corporations) are potentially eligible to exclude from taxation up to 50 percent of their gains on sale of QSBC stock.

Special 75 Percent Gain Exclusion Rule

The American Recovery and Reinvestment Act of 2009 increased the gain exclusion percentage from the longstanding 50 percent to 75 percent. However, the 75 percent exclusion rate only applies to sales of QSBC shares that were issued between February 18, 2009 and September 27, 2010.

Extra-Special 100 Percent Gain Exclusion Rule

Legislation enacted in 2010 and 2013 created an unbeatable 100 percent gain exclusion deal for sales of QSBC shares issued between September 28, 2010 and December 31, 2013. The 100 percent gain exclusion translates into a 0 percent federal income tax rate on gains when QSBC shares are sold down the road.

Holding Period Requirement

The gain exclusion breaks are only allowed for QSBC stock that you’ve held for more than five years.

Summary

    • The general 50 percent gain exclusion is potentially available for QSBC shares issued before February 18, 2009 and QSBC shares issued after December 31, 2013.
    • The special 75 percent gain exclusion deal is potentially available for QSBC shares issued between February 18, 2009 and September 27, 2010. Due to the more-than-five-year holding period requirement, the earliest possible date to cash in on the 75 percent gain exclusion is February 18, 2014.
    • The extra-special 100 percent gain exclusion is potentially available for QSBC shares issued between September 28, 2010 and December 31, 2013. Due to the more-than-five-year holding period requirement, the earliest possible date to cash in on the 100 percent gain exclusion is September 28, 2015. For QSBC shares that have not yet been issued, the 100 percent gain exclusion deal will only be available for sales that occur sometime in 2018 at the earliest.

The gain exclusion percentage is scheduled to drop back to 50 percent for shares issued after 2013 — unless Congress acts to extend it. Therefore, a December 31, 2013 share issuance deadline applies if you want to take advantage of the 100 percent exclusion deal.

This article covers federal tax law. There may be different rules in your state. Consult with your tax adviser about your situation.

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