One day, you had an idea for a business. Acting on your dreams, you formed a corporation and opened a business. As it turned out, your business was highly successful but now you would like to step back, sell your stock, and enjoy the fruits of your labors. But you hesitate because you really don’t want to pay such a huge tax bill.
Fear not. If your stock meets the requirements for qualified small business stock, 100% of the gain from sale of the stock can be excluded. That’s right – the sale can be totally non-taxable. But the rules are rather tightly drawn and therefore somewhat restrictive. Keep in mind that you don’t just happen to qualify, it must be planned years in advance. This is known as Qualifying Small Business Stock (QSBS)
Congress has played around with this portion of the law for years, primarily changing the time frame for when the stock was acquired and the percentage of gain that may be excluded. However, the 2015 PATH Act restored the provision for stock acquired after 2014, making the exclusion 100% for stock acquired after 2014. The exclusion applies to income tax as well as the AMT and is permanent. It might better be said that the provision does not expire. It is permanent only if Congress acts to change the law. As the gain is excluded from gross income, it would also not apply to the 3.8% net income investment tax.
First and foremost, the stock must be held for more than five years. The stock must be stock in a domestic C corporation, originally issued after August 9, 1993.
Second, as of the date the stock was issued, gross assets must be less than $50 million at all times after August 9, 1993. There is no limit to how large the corporation may grow.
Third, the taxpayer must have acquired the stock at its original issue directly or from an underwriter in exchange for cash or other property or services. Service as an underwriter do not qualify.
Fourth, as previously mentioned the corporation must be a domestic C corporation. It may have functioned as an S corporation previously if it was a C corporation for substantially all of the stockholder’s holding period. Due to this vague wording, going there is fraught with hazards. What constitutes “substantially all?” Additionally the corporation may not be a domestic international sales corporation (DISC), former DISC, regulated investment company, real estate investment trust, real estate mortgage investment trust, financial asset sterilization investment trust, a cooperative, or a corporation that has made a Sec 936 election.
Fifth, the corporation must be engaged in the active conduct of a qualified business. Eighty per cent of the value of the assets must be used in the active conduct of the business.
A qualified business cannot be one performing services in health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services. Also excluded are banking, insurance, financing, leasing, investing or similar businesses. If the primary asset is the reputation or skill of one or more employees, it is disqualified. A final limitation excludes farming, a business that can claim percentage depletion, or a hotel or restaurant.
Having survived all of those restrictions, you are probably asking about the limits on the amount that may be excluded. The exclusion is the greater of $10 million of gain or ten times the adjusted basis of the stock being sold. The $10 million cap is cumulative, but the second limit is calculated on an annual basis.
As stated at the beginning, this is a section of the law with numerous restrictions. To take advantage of these provisions requires advance planning, along with expert guidance in complying with all aspects of this law.
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