Owners of small businesses may find it easier to raise money in 2013. This is because, among the favorable tax breaks included under the American Taxpayer Relief Act (the “2012 Act”), there is a temporary extension of a provision that excludes 100 percent of gain arising from the sale of certain qualified small business stock (QSBS). This is a benefit small-business owners can use to entice investors, but it is important the owners understand what investors will be looking at in order to best position their companies to take advantage of the opportunity.
Under the right circumstances, for QSBS acquired during 2013, 100 percent of the gain from the sale of such stock will not be taxed. This falls under the alternative minimum tax rules as well as regular income tax. With an effective tax rate of zero percent — coming at a time when the effective tax rates on gains from the sale of capital assets have increased from 15 percent to 23.8 percent for certain high-income taxpayers — the QSBS exclusion is an extremely favorable tax provision and benefits both investors and businesses looking to raise equity.
In general, to qualify as QSBS, stock must be that of a domestic C corporation. Owners of other types of entities may consider changing their business to C-corp status, but should carefully weigh the pros and cons of such a decision — including the fact that C corporations are subject to double taxation. Additional requirements that must be satisfied to qualify as QSBS are:
- The stock must be acquired in an original issuance from the corporation in exchange for money, property or services;
- The aggregate gross assets of the corporation could not have exceeded $50 million at any time between Aug. 10, 1993 and immediately following the issuance;
- At least 80 percent of the corporation’s assets, determined by value, must be used in the active conduct of a trade or business; and
- The investor must hold the stock for more than five years before selling it.
The amount of gain from the sale of QSBS eligible for exclusion is generally limited to the greater of $10 million or ten times the taxpayer’s investment in the QSBS being disposed during the year.
Small businesses should expect that investors seeking to benefit from the QSBS rules will conduct due diligence about the company’s history. Such due diligence will typically include determining the historical gross assets of the issuing corporation and understanding how the corporation’s assets are used in connection with one or more qualifying trades or businesses. Further, the investors will be looking for representations from the issuing corporation, both historical and forward looking, to allow the investor to conclude that the issued stock is and will continue to qualify as QSBS.
Who Benefits, and How?
Special treatment available for taxpayers selling QSBS has existed since 1993. Compared to maximum long-term capital gain at that time, QSBS was a good investment. In the following years, the difference between QSBS and long-term capital gain decreased. But the 2012 Act again created a situation that makes QSBS investment more attractive — upon its sale, the benefit of investing in QSBS during 2013 can be as high as 23.8 percent of the gain.
Basically, for a corporation to be able to issue qualified small business stock, the adjusted basis of the corporation’s assets plus its cash on hand cannot have, on any day since Aug. 9, 1993, exceeded $50 million. And the corporation will be limited in how much qualified small business stock it can now issue based on the difference between $50 million and the sum of the total cash on hand plus the adjusted basis of the corporation’s other assets at the time of the issuance. There is a special rule if property other than cash was contributed to the corporation. Furthermore, a controlled group of corporations, consisting of a parent and any subsidiaries more than 50-percent parent-owned, are treated as one corporation for the purposes of the aggregate gross assets test.
The issuing corporation must be involved in the active conduct of a trade or business. For QSBS that relies on a business’s research and/or development activities, the R&D must be in connection with getting ready for a future active trade or business. Such activities qualify as an active trade or business even if the activities presently generate no income.
Some businesses are specifically cited as not meeting this definition. A corporation is not deemed to be involved in the active conduct of a trade or business if it provides services in the fields of health, law, engineering, architecture, accounting, actuarial sciences, performing arts, consulting, athletics, or financial or brokerage services; or if it is connected to banking, insurance, finance, leasing or investing, hotels or restaurants, farming or mineral extraction; or anything similar to these businesses or fields.
A corporation is also not deemed to be involved in the active conduct of a trade or business if more than 10 percent of its assets, by value, consist of real property that is not used in a qualified trade or business, and the ownership of, dealing in, or renting of real property is not treated as the active conduct of a qualified trade or business.
As a general matter, only individuals qualify for the QSBS exclusion rules. In addition, individuals who hold QSBS indirectly through an interest in a flow-through entity (such as a partnership, limited liability company or S corporation) may also qualify for the exclusion.
The current law automatically sunsets at the end of 2013. As a result, for QSBS acquired on or after Jan. 1, 2014, only 50 percent of gain from the sale of such stock is excluded for purposes of computing a taxpayer’s federal income tax. Although investing in QSBS after 2013 will continue to provide a more tax efficient alternative than investing in other stock, investing in QSBS in 2013 is much more beneficial.
There are many other tax considerations that may ultimately affect the net after-tax internal rate of return on an investor in a C corporation, all of which should be carefully analyzed before proceeding to form or convert into a C corporation. Business owners and taxpayers are strongly encouraged to consult with a tax professional familiar with these rules and the taxpayer’s particular situation.
Bahar Schippel is a partner at Snell & Wilmer and specializes in tax planning for mergers and acquisitions, fund formation, joint ventures and real estate transactions; drafting LLC and partnership agreements; structuring debt workouts; and designing service provider equity compensation for LLCs and partnerships.
William A. Kastin is a partner at Snell & Wilmer, where his tax practice focuses on business formations, mergers & acquisitions, real estate, §1031 “like-kind” exchanges, loan workouts and modifications, private equity transactions and daily operations.