Proposed Changes to Qualified Small Business Stock
On September 13th, the House Ways and Means Committee released a number of tax proposals that aim at raising revenue as part of the overall budget reconciliation process. While the proposals to increase the capital gains rates and the reduction of the estate tax exemption limit was anticipated, there was a new addition to the taxation of Qualified Small Business stock(QSBS).
Governed by Internal Revenue Code Section 1202[i], qualified small business stock allows for the exclusion of capital gains tax if certain criteria are met. The intention of the provision is to encourage investment in small businesses. While not an all-encompassing list, the main requirements for the gain exclusion are:
- The stock must be held for at least 5 years before sale
- The shares must be the original issue and from a domestic C corporation
- Immediately after the acquisition of the shares, the issuing corporation has $50 million or less in assets
- The issuing corporation is not in an excluded industry, such as law, farming, or restaurants
The industry that utilizes QSBS the most are those in the technology field. Under current law, if all of the criteria are met, the taxpayer may be able to exclude some or all of their capital gains from federal taxation. The amount of the exclusion depends on the year the shares were acquired. For purchases prior to February 18, 2009, the excluded gain on sale is 50%. For shareholders who acquired their shares between February 18, 2009 and September 27th, 2010, a 75% exclusion is permitted. Lastly, those stockholders who acquired their QSBS stock after September 27, 2010 may exclude 100% of their gain. The maximum exclusion is either $10 million or 10 times the adjusted basis in the stock.
Under the new proposal, the 75% and 100% exclusion amounts would be rolled back for taxpayers with adjusted gross incomes above $400,000. Shareholders that are above the threshold would receive the tax treatment prior to February 18, 2009, which was the 50% exclusion on their gain. In addition, the rules prior to 2009 dictated that the exclusion was an add back item for Alternative Minimum Tax(AMT) purposes. Moreover, trusts that hold 1202 stock would only receive the 50% exclusion, regardless of income limits. If the proposal is passed, it would apply to all sales of QSBS after September 13, 2021, unless they are part of a binding sale prior the announcement of the proposal.
This change in treatment is further exacerbated by the suggested changes to the capital gains rates. As an example, a founder who would have exited their business on September 12th, 2021 could have paid zero federal tax on a $10 million dollar sale if they met all of the criteria of section 1202. In contrast, under the new proposed legislation, the same founder would only be able to exclude 50% of their gain. They would pay a 25% capital gains tax plus a 3.8% Net Investment Income tax on $5 million of their exit. The proposed changes would add an additional $1,440,000 in taxes, excluding any AMT adjustments and the proposed 3% surtax on income above $5 million.
Clearly this changes the value proposition of QSBS for both founders and early investors. Advocates for 1202 stock argue that the tax benefit is provided to drive innovation and to offset some of the risk associated with early-stage companies. At this point, this proposal is still in committee, but it is certainly one to keep an eye on in the technology field.
[i] https://www.irs.gov/pub/irs-regs/ia2694.txt, Department of the Treasury
Chris Wall is a Certified Public Accountant and Certified Financial Planner. He best serves those with complex stock compensation needs, including Incentive Stock Options(ISO), Nonqualified Stock Options(NSO), Restricted Stock(RSU/RSA), and Employee Stock Purchase Plans(ESPP). His specialties include tax planning, cash flow analysis, distribution modeling, retirement planning, and withdrawal strategies.
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