With proper planning you can take advantage of Qualified Small Business Stock and avoid recognition of significant gain on the sale of that stock.

Not all stock sales are treated equally for tax purposes.

If you bought stock after September 27, 2010 and that stock is “Qualified Small Business Stock” (QSBS) as determined by Internal Revenue Code section 1202, you may be able to exclude 100% of the gain!

Example: Individual taxpayer invests $10,000 in a startup company and receives shares in exchange. The startup company is taxed as a C corporation. After 5 years the startup, which was very successful, is sold and the shares taxpayer owns are now worth $7,500,000. Without section 1202, taxpayer would generally recognize $7,490,000 of gain. Taxed at 15%, taxpayer would owe $1,123,500 in federal income tax. If the stock is QSBS purchased after September 27, 2010, taxpayer would owe no federal tax!

If given the chance, would you rather pay $1,123,500 in taxes or ZERO?

The rules of IRC 1202 provide a complex roadmap, which can lead to incredible tax savings.

Key Requirements of Qualified Small Business Stock

• The stock must be issued by a domestic C corporation (corporate stock with an S election won’t qualify)
• The stock must be owned by a taxpayer other than a corporation (think individuals, LLCs, and trusts)
• The stock must have been held for more than five years
• The company issuing the stock must be valued at no more than $50 million at the time of issue
• The stock must be acquired from the company directly (original issue) in exchange for cash, property, or services

What about contributions of property or real estate in exchange for stock?

Example: Individual taxpayer contributes property worth $500,000 to a startup company. Assume taxpayer’s adjusted basis in the property is $200,000. Assume also the initial contribution qualified as a tax-free contribution for purposes of IRC 351. If the stock is QSBS and sells for $4,200,000 (a gain of 740%!) only $3,700,000 ($4,200,000 less $500,000) will qualify as 1202 gain. That means taxpayer will still recognize gain of $300,000 on the initial investment ($500,000 less $200,000).

What if the stock appreciates to $50,000,000? How much gain can I exclude?

Section 1202(b)(1) provides that the gain excluded cannot exceed the greater of:

(A) $10,000,000 reduced by the aggregate amount of eligible gain taken into account under for prior taxable years and attributable to dispositions of stock issued by such corporation, or

(B) 10 times the aggregate adjusted bases of qualified small business stock issued by such corporation and disposed of by the taxpayer during the taxable year.

Generally, this equates to a lifetime exclusion of $10,000,000 per taxpayer. Married taxpayers are treated as a single taxpayer for this purpose.

What if I received stock in exchange for services?

Unheard of that a startup would need your time and energy more than your cash! But seriously, if you received restricted stock in exchange for your services, you are treated as having acquired the stock when that stock is included in your income. So, if you made an IRC 83(b) election to include the stock in your income, you are treated as if you purchased the stock on the date you made the election.

Do all corporate activities qualify?

No. The corporation must be actively engaged in a “qualified trade or business” during the holding period. And the corporation must use at least 80% of its assets in running its business.

Generally, any trade or business involving the performance of services in the fields of health, law (boo), engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees won’t qualify.

Similarly, banking, insurance, financing, leasing, investing, or similar business also won’t qualify.

Any farming business (including the business of raising or harvesting trees), any business involving the production or extraction of certain natural resources, and any business operating a hotel, motel, restaurant, or similar business also won’t qualify.

Note: startup activities count as if the corporation was actively engaged in the business during the startup phase.

What if I inherited the stock?

IRC 1202(h) provides that in a few situations, stock that was QSBS in the hands of the original owner will retain its character in the hands of another.

Stock acquired by gift, by inheritance, and in certain distributions from a partnership to a partner will be treated as if owned by the original owner.

BIG PLANNING OPPORTUNITY — This statutory exception can create planning opportunities that can result in significant tax savings.

Other considerations

There are other technical requirements built into the fabric of 1202. Given the potentially huge tax benefits, a thorough understanding of these requirements is essential before investing in a startup company. You should consult with experienced counsel before investing in an operating company (and preferably long in advance of) an exit event.