Most of the focus of the American Taxpayer Relief Act of 2012 (the “Act”) was on avoiding the fiscal cliff and the related increases in tax rates for most higher income taxpayers. One provision that has largely been overlooked is the extension of the “temporary” elimination of capital gains tax on sales of certain corporate stock. The same provisions (under Code Section 1202) had been in effect for part of 2010 and all of 2011, but had not been available for stock purchased on or after January 1, 2012. The Act not only extended this benefit through the end of 2013, but retroactively made it effective for all of 2012.
Under this provision, noncorporate taxpayers can exclude 100 percent of the gain realized on the sale of qualified small business stock (QSB Stock) acquired after September 27, 2010 and before January 1, 2014, and held for more than five years. No AMT preference will be applicable to the gain on the sale of QSB Stock, nor will the 3.8 percent Medicare tax on investment income of higher income taxpayers be imposed. Therefore, for QSB Stock issued between September 27, 2010 and the end of this year, there will be no federal tax of any kind imposed on the sale of QSB Stock if it is held for five years.
LLCs or partnerships that own QSB Stock can pass this exclusion through to their individual members or partners. If a partnership disposes of QSB Stock, the gain from the disposition is allocated among all the partners in accordance with its partnership agreement (and relevant tax rules). To the extent the gain is allocated to partners who held an interest in the partnership from the time it acquired the QSB Stock to the time of the sale, these partners are eligible for the tax exclusion on their proportionate share of the partnership’s gain, assuming the partnership held the stock for five years.
Another opportunity exists for companies adopting or utilizing already adopted stock incentive plans for their employees. QSB Stock includes stock issued as compensation for services provided to the corporation. The five year holding period requirement could provide a built-in incentive for employees to stay with the company for that period of time to enjoy a complete elimination of taxes on the eventual sale. The ability to sell the stock in the future and pay no taxes would certainly be seen as an added benefit by the recipient employee.
Corporations which previously issued options to employees may want to consider discussing an exercise of the options by the employees to take advantage of this exclusion. The exercise of an option normally results in compensation income to the employee/option holder, therefore, most employees do not exercise their options until an event (such as the sale of the company) happens that will provide cash proceeds to pay the tax. Given (i) the opportunity to pay no tax on the eventual sale of the stock; and (ii) the fact that, given today’s economy, the value of the company (which is determinative of the amount of income recognized by the employee upon the exercise of the option) may be low, an exercise of an employee-held option may be worth looking into.
Most advisors are reluctant to advise their clients to form a new business such as a C corporation in order to take advantage of these excisions. After all, the exclusions only apply to a sale of the company’s stock. If the company were sold in a transaction structured as an asset sale, the effective tax rate, taking into account both the corporate level of tax and the shareholder level of tax, would be well over 50 percent. Although the potential for an asset sale continues to make operating a business as a C corporation a risky proposition for a tax standpoint, the possibility of a complete elimination of tax on the sale of QSB Stock does provide a real incentive.
In order for stock to qualify as QSB Stock, it must meet the following basic requirements.
- It must be stock acquired as an original issuance from the corporation. While warrants and options do not qualify as QSB Stock, if this type of instrument is exercised to acquire QSB Stock, the exercise will be a qualifying acquisition (i.e., original issuance). The QSB Stock must be acquired for money, property (other than corporate stock) or services provided to the issuing corporation.
- The corporation issuing the stock must be a qualified small business. In general, a qualified small business is a C corporation with aggregate gross assets of less than $50 million at any time before (or immediately after, taking into account any monies invested by the stockholder) the issuance of the stock. The fact that the corporation’s assets increase and become worth more than this limit after the issuance is not relevant.
- The corporation must also meet an active business requirement, meaning the corporation uses at least 80 percent of its assets, measured by value, in the active conduct of one or more qualified trades or businesses. A qualified trade or business generally does not include service businesses, and specifically excludes banking and investment business. Start-up businesses can qualify as active trades or businesses even if they have generated no gross income.
Of course, there are a number of more detailed requirements that must be considered. For instance, there are limitations on the amount of stock and real estate that a corporation may hold and still be considered engaged in the active conduct of a qualified trade or business. Certain redemptions will cause the newly issued stock to not qualify. There is also a limitation on the amount of the gain that can be excluded. This amount is the greater of: (1) 10 times the taxpayer's basis in the corporation's QSB Stock disposed of by the taxpayer in the tax year, or (2) $10 million.
Because C corporations are often not tax efficient in many circumstances, a business owner starting a new business should carefully consider the potential tax drawbacks of operating as a C corporation; the potential to exclude gain under Section 1202 is a factor but not the determinative factor. For a business that is already operating as a C corporation, offering shares to employees or to investors will, through the end of this year, have the potential added bonus of allowing for a tax free sale of such stock.
For more information, please contact:
Mark Klimek 216.348.5453
Tax planning needs to be strategic. We consult with businesses at all stages of their development, from the initial choice of entity, through acquisition and other growth transactions, to business succession planning, and dispositions. Our tax advisors also work closely with clients on individual tax planning. Our attorneys provide businesses and individuals with comprehensive counseling in all areas of federal, state and local taxation.