On December 18, Congress passed and the President signed into law the Protecting Americans from Tax Hikes Act of 2015 (the “PATH Act”), a measure that, among other things, retroactively renews, extends and makes permanent certain tax incentives that expired on December 31, 2014. Of particular relevance for start-up and early-stage enterprises, the PATH Act retroactively reinstates the 100% exclusion for gain from the sale of certain qualified small business stock held for more than five years and that meets other requirements. Of even greater significance, the 100% exclusion has now been made permanent—rather than merely being extended on a stopgap basis.
What is QSB stock?
Qualified small business stock (“QSB stock”) is defined as capital stock of a domestic C corporation that operates an active business satisfying various requirements set forth in Section 1202 of the Internal Revenue Code (the “Code”). The rules are extremely technical and must be reviewed carefully on a case-by-case basis. Of particular importance, the corporation must use at least 80% of its asset value in the active conduct of one or more “qualified trades or businesses” (as defined in the Code), and its “aggregate gross assets” cannot exceed $50 million immediately after the stock is issued. Many companies in the new and emerging technology sector are potentially eligible to issue QSB stock.
By 2010, as part of an overall economic stimulus plan put in place in response to the Great Recession and the near collapse of our financial system, the Code’s preexisting exclusion of gains on sales of QSB stock held for more than five years had been increased, first from 50% to 75% and then from 75% to 100%, with the applicable percentage depending on when the stock was acquired. Prior to the enactment of the PATH Act, the 100% exclusion had been available only for QSB stock acquired on or before a “sunset” date of December 31, 2014, meaning that any QSB stock acquired during calendar year 2015 or thereafter—if held for the requisite five-year holding period—would have been eligible only for the original exclusion amount of 50%.
Now, however, as a result of the PATH Act, the 100% gain exclusion has been retroactively reinstated and made permanent—so that it applies to any QSB stock acquired after September 27, 2010 (the original date of enactment for the 100% exclusion), without any sunset date. The lesser gain exclusions (50% and 75%) continue to apply to QSB stock acquired within the specific window periods applicable to those exclusions. As an added tax incentive, no portion of the gain excluded by reason of the 100% exclusion is subject to the alternative minimum tax (“AMT”), in contrast to the operation of the 50% and 75% exclusions (under which a portion of the excluded gain is subject to AMT).
It is important to note that in all scenarios—whether the exclusion amount is 50%, 75% or 100%—the exclusion is available only for noncorporate taxpayers who hold QSB stock for more than five years, and there is a “cap” on the gain taken into account for each eligible corporation before being multiplied by the applicable exclusion percentage (such cap essentially being equal to the greater of $10 million or 10 times the basis of the stock sold, on a per-taxpayer basis). In addition, in order to be treated as QSB stock, the stock generally must be acquired by the taxpayer at its original issue (directly or through an underwriter); for example, stock purchased from a preexisting shareholder is not eligible. Whether the exclusion will be available for state or local income tax purposes will depend on each jurisdiction’s particular tax laws.
Related provisions of the Code also allow noncorporate taxpayers who acquire and hold QSB stock for more than six months (rather than five years) to elect to defer realized gain on the sale of the QSB stock by reinvesting the sale proceeds, within 60 days, into new QSB stock. The taxpayer’s basis in the new QSB stock is reduced by the amount of deferred gain. These deferral provisions were not affected by the PATH Act.
What does this mean?
QSB stock tax incentives provide an attractive motivation for (i) new investors to acquire stock in qualifying ventures (whether directly or indirectly through investment funds or other flow-through entities); (ii) holders of convertible debt, stock options and warrants issued by qualifying ventures to consider exercising their conversion or purchase rights; and (iii) entrepreneurs to consider organizing their ventures as C corporations in the first instance. While QSB stock tax treatment may be a factor in the initial choice of entity determination, the determination requires weighing a multitude of facts and circumstances (both tax and non-tax). Those of us in the start-up, early-stage and venture capital community are pleased that Congress has finally made the 100% exclusion permanent. We feel strongly, and there is substantial anecdotal evidence from our emerging growth and venture capital clients, that QSB stock tax incentives stimulate the start-up ecosystem by motivating entrepreneurial activity, innovation and investment in early-stage enterprises.