Publish Date

May 18, 2020

Overlooked the Tax Benefits of Qualified Small Business Stock? Take a Structuring Mulligan

Special Tax Alert

For many years, taxpayers have overlooked the significant gain exclusion benefits of owning Qualified Small Business (QSB) stock. But do not despair. Now may be the optimal time to plan into these provisions – either by deciding to operate a new business as a taxable corporation (C corporation) or incorporating a business previously held in a pass-through solution. Below, we supply a road map of what benefits are available and who may qualify.

Why Now?

Over the past decade, economic and regulatory influences have been building to create the “perfect storm” for taxpayers to avail themselves of the QSB provisions:

  • 2010 – Temporary expansion of the QSB incentive (increase in gain exclusion percentage to 100%);
  • 2015 – 100% exclusion made permanent;
  • 2017 – Tax Cuts and Jobs Act (TCJA) lowers the U.S. corporate rate to 21%;
  • 2020 – Global pandemic depresses values and creates a potential for massive domestic infrastructure and supply chain investment.

Today, these factors amount to a structuring “mulligan” – A chance for small business owners, private equity, and venture capital investors to re-evaluate and re-structure to achieve QSB benefits they may have missed including gain exclusion, gain rollover, or ordinary loss treatment.

Gain Exclusion (IRC Section 1202)

Individuals, trusts, and other noncorporate taxpayers may exclude some or all of the eligible gain from the sale of QSB stock, contingent upon the date acquired (up to 100% if acquired after September 27, 2010).

Eligible gain includes gain from QSB shares the taxpayer held for more than five years. The cumulative amount of eligible gain is generally the greater of $10 million or ten times the taxpayer’s original basis in the QSB shares per issuer.

For example, if an individual currently owns a business valued at $50 million in pass through solution, that individual may incorporate the business into a C corporation in a non-recognition transaction today (achieving basis equal to the value for Section 1202 purposes), sell the stock five years from now, and shield up to $500 million of gain (ten times basis of $50 million) from both individual Federal income tax and net investment tax. State benefits may also be available based on the individual’s profile as many states conform to the Federal QSB benefits. However, a review is recommended since certain states (e.g. California, New Jersey, Pennsylvania) limit the exclusion or decouple from the Federal provisions.

When significant business appreciation is expected (e.g. startups), this value proposition (up to $500 million of gain exclusion) often outweighs the negatives (e.g. double tax on distributions, potential rate increases, discounted exit value for lack of buyer step-up). If structured properly in conjunction with certain estate tax planning, the gain exclusion may increase even further (e.g. by taking advantage of the per issuer limitation). Scenario analysis of QSB benefits (or identification of existing QSB benefits) is worthwhile for any noncorporate taxpayers with stock fitting the below profile…