Reducing the Tax on QSBS Sales    

Tax professionals with clients who have or are about to sell their businesess should become familiar with Sec. 1202, which allows noncorporate investors to exclude up to 50% of the gain realized on the sale of qualified small business stock (QSBS) held for more than five years.

In order to be QSBS, such stock must be in a C corporation, originally issued after Aug. 10, 1993 and acquired by the taxpayer at original issue. In addition, the corporation must be a "qualified small business" as of the date of issuance and must meet "active business" requirements during the taxpayer's holding period of the stock.

The requirement that the stock be acquired at original issue is fulfilled by the taxpayer acquiring the stock directly from the corporation, through an underwriter in exchange for money or other property (not including stock) or as compensation for services provided to the corporation. Stock acquired by a partner from his partnership is also regarded as acquired at original issue if, at the time of the transfer to the partner, the stock was QSBS in the partnership's hands and the partner held his partnership interest at the time the partnership acquired the stock and at all times until the partnership disposed of the stock. This enables stock distributed by venture capital funds to potentially qualify as Sec. 1202 stock.

The corporation will be considered a qualified small business if it is a domestic C corporation whose aggregate gross assets at all times on or after Aug. 10, 1993, before the stock issuance and immediately after the stock issuance, did not exceed $50 million. "Aggregate gross assets" include cash plus the adjusted bases of other property held by the corporation.

The active-business requirements for the corporation are generally two: (1) the corporation must use at least 80% of the value of its assets in the active conduct of at least one qualified trade or business and (2) the corporation must be an "eligible corporation." A "qualified trade or business" is any trade or business other than a trade or business involving the performance of services in health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services and brokerage services; any banking, insurance, financing, leasing, investing or similar business; any farming business; any business involving the production or extraction of oil, gas and other natural deposits; and any business of operating a hotel, motel or restaurant.

Generally, the active business requirement is not met if a corporation has more than 10% of the value of its assets in stock or securities of other corporations or real property not used in the active conduct of a qualified trade or business. Like the "qualified trade or business" requirement, the "eligible corporation" requirement is also defined in the negative as a domestic corporation and not a domestic international sales corporation (DISC) or former DISC; a corporation for which a Sec. 936 election is in effect; a regulated investment company, real estate investment trust, financial asset securitization investment trust or real estate mortgage investment conduit, or a cooperative.

If all of the requirements are met, noncorporate taxpayers may exclude 50% of the gain realized on the sale. However, the gain eligible for the 50% exclusion is limited to the greater of $10 million less all eligible gain taken into account by the taxpayer in earlier years or 10 times the taxpayer's total adjusted basis in QSBS of the corporation disposed of by the taxpayer during the tax year. Further, the taxpayer is not entitled both to exclude 50% of the gain on the sale of stock and to tax the balance of the gain subject to tax at the 20% rate. The gain subject to taxation is taxed at 28%. For many taxpayers, the 50% exclusion and the 28% tax rate applying to the balance of the gain result in an effective rate of 14% on the total gain.

Unfortunately, for many taxpayers the benefit of the exclusion for Federal purposes is virtually eliminated because of the alternative minimum tax (AMT). The gain excluded from gross income is treated as a preference item and is therefore added back in computing alternative minimum taxable income (AMTI). As a result, 71% of the gain subject to the exclusion is included in AMTI; thus, the maximum effective rate of tax is 19.88%, a very slight savings.

However, there are potential benefits not diluted by the AMT if one looks to the state tax consequences and the benefit that may be derived (depending on the state involved). Because many states adopt Federal rules but do not tax capital gains differently than other income, the 50% exclusion from the sale of QSBS may serve to reduce a taxpayer's state tax burden. If a state imposes a tax on income calculated for Federal purposes that allows a 50% exclusion from the sale of QSBS and the state does not impose a minimum tax based on AMT, a state tax benefit may be derived from the election. Such is the case, for example, in New York, where a New York City resident must include only half of the capital gain subject to the combined New York State and City rate of almost 11%. Effectively, this results in a tax of 5¹/2% on the entire gain. Although New York has a minimum tax that includes Federal preference items, the computation will rarely generate a state minimum tax. For an AMT taxpayer, the state savings are even more meaningful, as state taxes are not allowable for the AMT.

Although there is currently no statutory requirement that the corporation maintain records to qualify for the exclusion, it would seem to make good business sense and be in the seller's best interest to obtain whatever records prove the stock qualifies as Sec. 1202 stock. The seller could best secure the records at the time of preparing the tax return or prior to sale; afterward, there may be significant changes in procedures, personnel and files due to new ownership.

In summary, the exclusion for QSBS may be of great benefit to clients who meet the requirements. Even for those whose benefit is virtually eliminated because of the AMT, the state tax benefit derived may prove to be substantial. The detailed requirements necessitate a great deal of fact-finding, but the reduced tax comes with no downside.

From Elda DiRe and Christopher Rohde, Ernst & Young LLP, New York, NY. Ms. DiRe is a member of the AICPA Individual Income Taxation Technical Resource Panel.