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Want to pay ZERO federal income tax on potentially millions of dollars of income? For some, it’s a reality.

To encourage and support entrepreneurship, the federal government provides a tax break to angel investors and others who invest in the stock of startups and small businesses. The tax break is based in Section 1202 of the Internal Revenue Code and goes something like this: If you’ve invested in the stock of a qualifying business and you sell that stock for a gain, some or all of the gain is exempt from federal income tax.

Of course, there is a limit to the amount you can exclude and there are rules that your investment must satisfy to qualify.

It’s essential to understand and be able to apply these rules if you want to maximize the after-tax return on your investment.

Background

The PATH Act of 2015 expanded and made permanent the federal tax benefit for investments in Section 1202 stock, otherwise known as Qualified Small Business Stock (QSBS or QSB stock).

As a general rule, if you own qualifying stock long enough and meet all of the other requirements, you can exclude your gain when you sell the stock, potentially up to $10 million. This includes stock you acquired by exercising compensatory stock options.

Importantly, under the new rules, the untaxed gain is not subject to the Alternative Minimum Tax (AMT) and also not subject to the 3.8 percent Medicare tax on Net Investment Income — all of which further enhances your potential after-tax return on the investment.

Who is Eligible for the Tax Benefit

Generally, individual investors can qualify, as well as certain pass-through entities where taxes flow through to the individual tax return.

Eligible pass-through entities include partnerships, S corporations, certain trusts and regulated investment companies — as long as they satisfy all of the tax rules for excluding these gains. In addition, the individual that the exclusion flows through to must have owned his or her interest in the entity when the stock was acquired by the entity and at all times thereafter.

Corporations are not eligible for this benefit.

Percentage of Excludable Gain

For qualifying QSB stock acquired after September 27, 2010, the new tax rules allow you to exclude 100 percent of the gain.

That wasn’t always the case. Initially, under the old rules, the exclusion was only 50 percent and, for a time, 75 percent. So the percent of gain you can exclude actually depends on when you acquired your QSB stock.

Date QSB Stock Was Acquired Percent of Gain Excludable
August 11, 1993 – February 16, 2009  50 percent
February 17, 2009 – September 27, 2010 75 percent
September 28, 2010 and after 100 percent

As a result, it’s particularly important to retain documentation to support the exact date(s) you acquired the QSB stock.

Limitations on Excludable Gain

There is a cumulative limit on the amount of gain you can exclude from a single corporate issuer. In other words, the limit is per taxpayer, per issuing corporation.

That limit is the greater of the following:

  $10 million ($5 million if married and filing separately), reduced by the total amount of eligible gains you’ve excluded in prior years for dispositions of the same issuer’s stock

  10 times your basis (excluding basis increases post-issuance) in all of the issuer’s qualified stock that you disposed of during the tax year

Any additional gain is taxed at the capital gains tax rate.

Requirements for Excluding Gain

The major requirements to qualify for exclusion under the federal QSBS tax rules are as follows:

  Acquisition at Original Issuance
You must have acquired the QSB stock, directly or through an underwriter, at the time the stock was originally issued. However, you are not limited to the company’s initial stock offering; the tax benefit also applies to any subsequent stock issuance.

You must have acquired the QSB stock after August 10, 1993 in exchange for money, property other than stock, or services other than underwriting.

  Holding Period
You must have held the qualifying stock for more than five years.

  Qualifying Companies (Stock Issuers)
The tax rules impose a number of requirements regarding the company that issues the stock:

  Entity  At the time the stock was issued and for substantially all the time you held it, the issuer must have been a U.S. C corporation. S corporations and LLCs, for example, do not qualify. Other entities that do not qualify include a domestic international sales corporation (DISC), possessions corporation, regulated investment company (RIC), real estate investment trust (REIT) and a cooperative.

  Assets  The issuer’s gross assets cannot have been more than $50 million before or immediately after it issued the stock. Note that, for certain affiliated groups, the asset test is applied at the group level. If the company’s (or group’s) gross assets later exceed this amount, previously qualified stock is not affected.

  Qualified Trade or Business  For substantially all the time that you held the stock, more than 80% of the issuer’s assets (including those of any subsidiaries) must have been used in the active conduct of a qualified trade or business. This is tricky, subject to some degree of interpretation.

Investment vehicles and many service business do not qualify— including those in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, athletics, financial services, brokerage services and consulting fields, and others if the principal asset is the reputation or skill of one or more employees. Similarly, banking, insurance, financing and leasing business to not qualify. Hotels, motels and restaurants are also excluded, as are farming businesses and certain businesses eligible for a percentage depletion deduction.

Manufacturing, transportation, wholesale and technology businesses typically qualify, as do startup, research and experimentation activities, as well as in-house research expenses.

To protect your tax benefit, when you purchase the stock or as soon as possible after, it’s a good practice to ask the company for documentation that certifies it meets these requirements.

Rollover of Gain for Stock Held More Than Six Months

For stock that doesn’t qualify for exclusion because you haven’t held it for the required five-year period, there’s another option.

If you held the stock for more than six months and sold it for a gain, you can elect to roll that gain over to new stock — thus deferring the gain for tax purposes. However, any gain that is considered ordinary income (rather than capital gain) is not eligible for the rollover.

To qualify for the rollover, you must purchase the new stock within 60 days of the sale date of the previously held stock.

Your holding period for the new stock includes the holding period of the stock you sold, with one exception: You must hold the new stock for more than six months to qualify for another rollover.

Any capital gain you roll over reduces your basis in the new stock.

When you subsequently sell that stock, your new gain (loss) is equal to the stock’s selling price less its tax basis, factoring in the basis reduction for the gain you’ve already rolled over. If you’ve held the stock for more than five years at that point — including the holding period(s) for any previous stock with rolled-over gain — and satisfied all other requirements, you exclude your gain under the QSBS rules. Alternatively, if it’s been more than six months but not more than five years, you can once again roll over the gain.

Special Rules for Certain Corporate Transactions

For certain types of corporate transactions, if you exchange qualifying stock for stock that does not qualify on its own merits, the nonqualifying stock is treated as QSB stock for tax purposes.

These transactions include the following:

  reorganizations where the original stock issuer is acquired by another corporation

  corporate formations where the shareholders in the original stock issuer transfer their QSB stock to a new corporation, and subsequently control 80 percent or more of the voting stock of the new corporation

The acquisition date of the original QSBS stock carries over to the new stock for purposes of determining the holding period.

 

Investing in a startup is a great way to give back to young and aspiring entrepreneurs.

Give us a call if you’re an angel investor. We can help.

SCOTT USHER
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ANGELA BAILOR
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