Internal Revenue Code (IRC) §1202 provides noncorporate taxpayers the opportunity to exclude part or all gains from investments in qualified small business stock (QSBS). This exclusion percentage has been modified over time and is currently listed in the Build Back Better Act (H.R. 5376) for significant modification. As of this writing, the latest version of the bill is documented in the House Rules Committee Print 117-18 (RCP 117-18). It passed the U.S. House of Representatives in November 2021 and proceeded to the Senate. As a result, investors holding QSBS may need to keep an eye on this issue and be prepared to possibly revisit their current position on holding or liquidating these investments in their portfolio.
SECTION 1202 QUALIFYING PROVISIONS
Not all stock issued by a small business is QSBS. A company must first satisfy rules defining a qualified small business (QSB). As provided in IRC §1202(d), any domestic C corporation (not an S corporation) is a QSB whereby:
- Its aggregate gross assets didn’t exceed $50 million before the stock was issued and immediately after the stock was issued, and
- The corporation agrees to submit reports to the Secretary of the Treasury and to shareholders as the Secretary may require.
Gross assets include assets of any predecessor of the corporation. All corporations that are members of the same parent-subsidiary controlled group are therefore treated as one corporation.
Once a company satisfies the QSB rules, then a set of rules are applied to determine whether its issued stock satisfies the QSBS rules. IRC §1202(c) provides that any stock is QSBS whereby:
- The stock is acquired by the taxpayer at its original issue (directly or through an underwriter) in exchange for money or property (but not stock) or as compensation for services rendered to the corporation;
- The QSB satisfies the active business requirement, meaning at least 80% (by value) of the corporation’s assets are used in the active conduct of one or more qualified trades or businesses; and
- The QSB doesn’t make certain purchases of its own stock (i.e., from the taxpayer or someone related to the taxpayer) during a four-year period beginning two years before the issue date, or it doesn’t significantly redeem its stock within a two-year period beginning one year after the issue date.
A taxpayer may qualify as the original owner of the QSBS if the individual acquired the stock from another person who met the requirements or through a conversion or exchange of the QSBS that the taxpayer held. For example, a person may qualify if the QSBS is acquired as a gift or an inheritance.
SECTION 1202 TAXPAYER BENEFITS
Taxpayers, other than a corporation, that acquire QSBS can exclude from gross income a percentage of eligible gains from the sale or exchange of the stock if it’s held for more than five years. Eligible gains are defined in IRC §1202(b) to be the greater of:
- $10 million reduced by any aggregate amount the taxpayer excluded from sales or exchanges of QSBS from the same issuer in prior years, or
- 10 times the aggregate adjusted bases of the QSBS issued by the corporation and disposed of by the taxpayer during the taxable year, as measured on the original issue date.
The eligible gain’s exclusion percentage varies based on when the QSBS was initially issued: It’s 50% if the QSBS was issued prior to February 18, 2009; 75% if the QSBS was issued after February 17, 2009, and prior to September 27, 2010; and 100% if it was issued after September 26, 2010.
The reporting of a sale or exchange of QSBS appears on Internal Revenue Service (IRS) Form 8949, Part II, with the appropriate box checked (i.e., Box D, E, or F) to note whether the cost of the stock has been reported to the IRS. Section 1 of Form 8949 provides the details of the sale or exchange by providing the company name, dates, proceeds, and costs. To show the exclusion amount per the IRS instructions to Form 8949, the code “Q” is entered in column F and the exclusion amount (50%, 75%, or 100%) is given in column G as a negative amount (in parentheses). The difference between the amounts shown in column D (sale or exchange price) and column E (cost or other basis), combined with column G (exclusion amount), is recorded in column H (taxable gain amount) and is carried over to Schedule D.
The House recently passed the Build Back Better Act that would modify this gain exclusion. Section 138149 of the RCP 117-18 version of the House bill proposed a change that would eliminate the 75% gain exclusion and the 100% gain exclusion for taxpayers with adjusted gross income (AGI) of $400,000 or more. If enacted, this would be a retroactive change for taxpayers selling or exchanging their QSBS because it’s effective for transactions occurring on or after September 13, 2021.
But not all is lost if the proposed legislation finds its way into the final bill: These taxpayers would be eligible to elect the 50% gain exclusion that currently applies to QSBS issued before February 18, 2009. Therefore, taxpayers wouldn’t pay long-term capital gains tax of 20% on the entire gain; they would only pay it on half the gain.
But there were other tax law changes in the proposed legislation to be aware of. First, Section 138202 of the earlier House bill proposed to raise the capital gains tax rate from 20% to 25%. So taxpayers selling or exchanging their QSBS would have incurred a higher capital gains tax on the 50% gain that’s subject to tax. That proposed increase has been eliminated in the RCP 117-18 version, but it may come back as the bill makes its way through the Senate.
Second, another proposed change in Section 138206 of the earlier House bill was to impose a surcharge on a taxpayer’s modified AGI in excess of $5 million. In RCP 117-18 Section 138203, the surcharge on a taxpayer’s modified AGI is now in excess of $10 million instead of $5 million. Thus, those taxpayers beneath the $10 million threshold could still find themselves above it because they would now be required to recognize a portion of the gain from their QSBS transactions.
Although this proposed legislative change may undergo further changes as the bill passes through the Senate, it does indicate to taxpayers what may appear in future legislation. Because Congress had to trim down its aggressive initial Build Back Better bill of $3.5 trillion to around $2 trillion, this may become a source for future revenue if Congress elects to push through some of the dropped programs from this legislation. So, this might be a good time to reassess your thoughts on retaining or disposing of any QSBS holdings.
© 2022 A.P. Curatola