By Jeremy Huish, Capstone Headwaters
For those that qualify, one often overlooked federal tax exclusion applies when the sale of stock qualifies as sale of Qualified Small Business Stock (QSBS) as defined in tax code section 1202.
Section 1202 provides a federal exclusion of some or all federal capital gains tax. The amount of eligible capital gain that may be excluded from federal income tax is equal to the greater of (i) $10,000,000 (less any QSBS benefit used in prior years) or (ii) 10 times the aggregate adjusted basis of QSBS that the taxpayer sold during the current tax year.
The qualifications to get QSBS treatment have some similarities and differences to the section 1042 qualifications, but there are important differences. Under Sec. 1202, no qualified replacement property is required. No minimum stock sale percentage is required. There is no requirement that the sale must be to an ESOP (although it can be). The election requires the business to be a C corporation, the seller needs to be selling stock acquired directly from the corporation that has been held for more than five years, at least 80% of its assets were used in an “active business” for substantially all of that period, and the gross assets of the business must never have been over $50 million prior to the issuance of QSBS. If there is an ESOP, there are no restrictions on how soon the ESOP can sell the acquired stock under section 1202 and no prohibition on allocating ESOP stock to any employees. The following types of businesses are not eligible under Section 1202: service businesses such as health, law, engineering, architecture, accounting, consulting, athletics, financial services and brokerage services; banking, insurance, finance, leasing, real property rentals, and investing; farming; natural resources such as oil and gas; and hotels and restaurants.
For stock acquired after August 9, 1993, but before February 18, 2009, 50% of the eligible capital gain is excluded from income tax; for stock acquired on or after February 18, 2009, and through September 27, 2010, 75% of the eligible capital gain is excluded from income tax; and for stock acquired on or after September 28, 2010, 100% of the eligible capital gain is excluded from income tax.
Planning can increase the eligible exclusion amount for QSBS. For example, two business partners who own QSBS in the same C corporation can each have their own $10 million QSBS limit. A company that reorganizes to become a C corporation and issues new stock will have an aggregate adjusted basis in that QSBS equal to the fair market value of those shares at the time they were issued with the reorganization. The 10 times aggregate adjusted basis limitation could be far greater than $10 million in this situation.
Assume for these examples that, unless otherwise stated, all necessary requirements are satisfied for both QSBS and section 1042.
Example 1. Business formed in 2011 as a C corporation. In 2020 the business owner decides to sell 100% of his stock to the ESOP in 2020 for $10 million. The owner has the option of using either section 1042 or QSBS to defer or exclude federal tax on that sale.
Example 2. Business formed in 2011 as an LLC and taxed as a partnership. In 2020 it reorganizes to become a C corporation, issues new stock, and 30% of the stock is sold to an ESOP. The owner elects section 1042 to defer that gain. Six years later the owner decides to sell the remaining 70% of the stock to the ESOP. The owner could elect section 1042 to defer all of his gain on this 70% stock sale. Alternatively, the owner could use QSBS treatment to exclude the gain on this 70% stock sale for the amount that the QSBS appreciated since the time it was issued until sold to the ESOP. Note that the excluded amount under QSBS is capped at 10 times the aggregate adjusted basis of the owner’s stock at the time of conversion from the LLC to the C corporation. The owner would owe capital gain tax on the amount of gain between his original tax basis up to his aggregate adjusted basis in that QSBS.
Example 3. Same facts as example 2 and the remaining 30% of the company is sold to the ESOP. However, when the time comes for the second sale, the owner and ESOP trustee decide to sell 100% of the business to a strategic buyer. The owner chooses not to pursue 1042. The owner can exclude QSBS gain from selling 70% of his stock subject to applicable QSBS limits. There is no taxable gain on the ESOP’s portion of the stock sold. The proceeds from the ESOP’s 30% would be contributed to the individual employee’s retirement accounts.