Capital Gains Exclusion for Small Business Stock Held for More Than 5 Years I. Background. By Stephen D. D. Hamilton, July 2011 A. Enactment of exemption. The Creating Small Business Jobs Act of 2010, enacted in September 2010, created an exemption from capital gains tax for investments in certain qualifying C corporations made between September 28, 2010 and December 31, 2010, if held for more than 5 years. P.L. 111-240, 760(a). B. Extension of exemption. The Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, enacted in December 2010, extended that provision to cover investments made during 2011 as well. P.L. 111-312, 753(b). C. Application of section 1202. In each case, the exemption applies to shares of qualified small business stock that meet applicable requirements of Internal Revenue Code ( IRC ) 1202, which was originally enacted in 1993 to provide a partial exclusion. The 2010 amendments effectuated the exemption by increasing the applicable percentage of the gain that is excluded under 1202 to 100%. D. C corporation requirement. Only a C corporation can issue stock that qualifies under 1202. IRC 1202(c)(1). Therefore, if a business will otherwise qualify for 1202 treatment, the availability of that potential exclusion for gain on stock held for more than 5 years is a significant potential advantage of C corporation status to be weighed against the competing advantages provided by structuring the company as a limited liability company, S corporation or other pass-through entity. II. Eligible Taxpayers. Taxpayers eligible for the exclusion are individuals, trusts and estates. IRC 1202(a). A. Pass-through entities. Besides shares owned directly, shares may be held through pass-through entities, including partnerships, S corporations, regulated investment companies ( RICs ) and bank common trust funds. IRC 1202(g). B. Two relevant holding periods. If shares are held through an entity, the entity must meet the 5-year holding period and the taxpayer must have held his interest in the entity since the date the entity acquired the stock. IRC 1202(g)(2). Gain is not excludable to the extent it exceeds the portion attributable to the taxpayer s interest in the entity at the time the entity acquired the stock. IRC 1202(g)(3). C. COMMENTS: 1. The statutory holding-period requirement for shareholders of RICs is somewhat cumbersome to implement, because it requires RICs to include with each individual shareholder s Form 1099-DIV a separate statement 1
2. Partnerships may wish to try to specially allocate the gain on qualified stock to partners in proportion to their interests at the time of acquisition of the stock. In some circumstances, this result may be achieved through 704(c) and reverse 704(c) allocations. III. Eligible Stock. To be eligible, stock must meet four requirements: A. Original issuance. 1. Stock must have been acquired by the taxpayer after August 10, 1993 at the original issuance (directly or through an underwriter) in exchange for money, other property (not including stock) or as compensation for services provided the issuing corporation (other than services performed as an underwriter of the stock). IRC 1202(c)(1). 2. The corporation generally cannot have repurchased more than 5% of its stock within one year of the issuance date or have repurchased any stock from the taxpayer (or a related person) within 2 years of the issuance date. IRC 1202(c)(3). a. 5% is determined based on the aggregate value of the shares redeemed, at the time of each redemption, as compared to the aggregate value of shares outstanding as of the beginning of the 2- year testing period. Treas. Reg. 1.1202-2(b)(1). b. Repurchases in connection with retirement, death or other termination in service of employees or directors, and repurchases incident to a divorce of a shareholder, are disregarded. Treas. Reg. 1.1202-2(d). c. Repurchases from the taxpayer (or a related person) of de minimis amounts are disregarded. For this purpose, de minimis means no more than the greater of (i) $10,000 and (ii) 2% of the stock held by the taxpayer and related persons. Treas. Reg. 1.1202-2(b)(2). 3. COMMENTS: a. An exercise of an option to acquire stock, including an exercise of the conversion feature on convertible debt, should probably be considered an issuance of stock in exchange for money or other property. See, e.g., IRC 1271(a)(1) (amounts received on retirement of debt instrument shall be considered amounts received 2
b. If a public offering involves both a primary and a secondary offering, and the shares otherwise meet the requirements of 1202, presumably a pro rata portion of the shares purchased by each buyer should be treated as qualified stock. But only a relatively small public offering may qualify for 1202 treatment in any event, given the $50,000,000 gross asset basis limitation. See III.D infra. c. In planning for a future offering, this provision may be a reason to capitalize a company with as much debt as possible because debt can be paid off with offering proceeds without disqualifying the newly issued shares from 1202 status, even if the debt is owed to existing shareholders. B. Eligible corporation. An eligible corporation is a C corporation other than a DISC, a 936 corporation, a RIC, a REIT, a REMIC or a cooperative. IRC 1202(c)(4). COMMENTS: 1. Presumably, partners in an existing partnership who wish to avail themselves of 1202 can convert their partnership into a C corporation and thereby obtain the benefit of the exclusion for subsequent appreciation over a 5-year or longer period. 2. By contrast, shareholders in an existing S corporation cannot obtain the benefit of 1202 even if they terminate their S election or contribute their S corporation shares to a newly formed holding company. C. Active business. During substantially all of the taxpayer s holding period, at least 80% (by value) of the corporation s gross assets (including intangible assets) must have been used in the active conduct of a qualified trade or business. IRC 1202(c)(2)(A), (e)(1)(a). 1. A qualified trade or business is any trade or business other than: a. the performance of services in the fields of health, law, engineering, architectural, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage 3
b. any banking, insurance, leasing, financing, investing or similar business; c. any farming business; d. any business for which percentage depletion is allowable; or e. any business operating a hotel, motel, restaurant or similar business. IRC 1202(e)(3). 2. In addition, as a general matter, a. no more than 10% of the corporation s gross assets can consist of real property not used in the active conduct of a qualified trade or business, and b. no more than 10% of the corporation s net assets can generally consist of portfolio stock or securities other than reasonably required working capital. IRC 1202(e)(5)(B), (e)(7). 3. For purposes of the active business test, activities conducted by, and assets held by, 50% or greater subsidiaries are treated as conducted, or owned, proportionately by the parent corporation. IRC 1202(e)(5). 4. A corporation that is licensed by the Small Business Administration as a specialized small business investment company under 301(b) of the Small Business Act of 1958 (as in effect on May 13, 1993) will be treated as automatically meeting the active business test. IRC 1202(c)(1)(B). 5. COMMENTS: a. By reason of the statutory exclusions, most qualified businesses will be manufacturing, sales or distribution businesses. b. If a corporation conducts one or more qualifying and one or more nonqualifying business, its eligibility may be quite uncertain because it is the fair market value of the assets (including goodwill and other intangibles) used in each business that is dispositive, and such value may be elusive and fluctuating. D. Gross assets. Immediately after the issuance of the stock, and at all prior times on or after August 10, 1993, the corporation s aggregate basis in its gross assets cannot have exceeded $50 million. IRC 1202(d)(1). 4
1. Contributed assets are treated as if their basis equaled their fair market value as of the time of contribution. IRC 1202(d)(2). 2. Assets of 50%-or-greater subsidiaries are combined with a parent corporation s assets for purposes of the gross assets limit. IRC 1202(d)(3). 3. COMMENT: a. Because the $50 million test applies only to a corporation s gross tax basis in its assets at any given point in time, a start-up company is not precluded from obtaining cumulative infusions of cash over time that exceed $50 million, provided that the money is spent. b. If equity offering proceeds are immediately used to pay off longterm debt, it appears that those proceeds will nonetheless count towards the $50 million cap under the literal terms of 1202(d)(1)(B), even though they are part of the gross assets of the corporation only momentarily. IV. Holding Period Requirement. The qualified stock must be held for more than 5 years. IRC 1202(a)(1). A. Tacking of holdings periods. Tacking applies for transfers by gift, at death or from a partnership to a partner. IRC 1202(i)(2). Tacking does not apply to other tax-free transfers, such as transfers by a partner to a partnership. Conf. Rep. at 12. Thus, for example, if a partnership undergoes a 708(b)(1)(B) termination upon a sale or exchange of 50% or more of the interests in partnership capital and profits within a 12-month period, the partners may lose all 1202 benefits for stock held by the partnership inasmuch as the stock is deemed to be contributed to a new partnership. Treas. Reg. 1.708-1(b)(4). B. Exchange for non-qualified stock. Gain realized upon a tax-free exchange of qualified stock for other stock will be eligible for the exclusion when the other stock is ultimately disposed of in a taxable transaction. IRC 1202(h)(4). V. Amount of Exclusion. The amount of the exclusion for gain recognized during a taxable year is a certain percentage of the gain that does not exceed the greater of (i) $10 million (reduced by gain taken into account in prior years) or (ii) 10 times the taxpayer s aggregate basis in qualified stock of the corporation that is disposed of during the taxable year. IRC 1202(a), (b). A. Applicable percentage. The percentage depends on when the stock is issued: 1. 100% for stock issued from September 28, 2010 through December 31, 2011. IRC 1202(a)(4). 5
2. 75% for stock issued from February 17, 2009 through September 27, 2010. IRC 1202(a)(3). 3. 50% for all other stock issued after August 10, 1993. IRC 1202(a)(1). B. Relevant gain. Only gain that accrues after the stock is issued is eligible for the exclusion. Thus, if stock is issued in a tax-free exchange for property, the basis of the stock for purposes of computing excludable gain is treated as not less than its fair market value at the time of the exchange. IRC 1202(i). C. Other gain. Any 1202 gain that is not excluded from gross income is taxable at a maximum rate of 28%. IRC 1(h)(4), (7). D. Alternative minimum tax. Gain that is 100% excluded for regular tax purposes is also 100% excluded for alternative minimum tax ( AMT ) purposes. IRC 1202(a)(4)(C). In other cases, a portion of any excluded gain is included in income for AMT purposes. IRC 57(a)(7). E. COMMENT. For purposes of the 10 times basis calculation, basis of shares disposed of in the same taxable year are aggregated. So a taxpayer who sells two or more blocks of stock, with differing basis amounts, is allowed to aggregate those them provided that the dispositions are in the same taxable year. 6