On September 27, 2010, President Obama signed into law the Small Business Jobs Act of 2010 (H.R. 5297), which included among many other provisions, a short-term 100 percent exclusion (subject to per issuer limitations) from gross income of gain derived from qualified small business stock (QSBS) held for more than five years, if such stock was purchased after the enactment date and before January 1, 2011. The 100 percent exclusion is an attempt to encourage investment in new ventures, small businesses, and specialized small business investment companies.
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Prior to the enactment of 2010 Small Business Jobs Act, Code Section 1202 provided for the exclusion of 50 percent of a non-corporate taxpayer's gain from QSBS (60 percent for gain attributable to QSBS in certain tax-favored areas). The American Recovery and Reinvestment Act of 2009 increased the exclusion to 75 percent for any QSBS acquired after Feb. 17, 2009 and before Jan. 1, 2011. Because the exclusion in all cases was based on a 28 percent rate (as opposed to the 15 percent capital gains rate in effect), the 50 percent exclusion resulted in a 14 percent effective tax rate and the 75 percent exclusion resulted in a 7 percent effective tax rate. However, for purposes of calculating alternative minimum tax (AMT), a percentage of the excluded gain was a preference item, and, thus, included in income. As a consequence, the benefits provided under Section 1202 were in many cases not worth the administrative burden of qualifying for such benefits.
The 2010 Small Business Act provides that for QSBS acquired
after Sept. 27, 2010 and before Jan. 1, 2011:
Accordingly, for QSBS acquired after September 27, 2010 and on or before December 31, 2010, the 100 percent exclusion may actually, really and truly result in a 100 percent exclusion. For QSBS stock acquired on or after January 1, 2011, the 50 percent exclusion will be back in force and the AMT preference inclusion will again apply. (And, of course, for QSBS acquired after enactment of Section 1202 and before February 17, 2009, the 50 percent exclusion will continue to apply and for QSBS acquired on or after February 17, 2009 and before September 27, 2010, the 75 percent exclusion will continue to apply. The AMT preference inclusion will also continue to apply in those cases.) NASBIC and other groups are lobbying to have an extension of the 100 percent exclusion and AMT preference elimination included in an extenders bill.
The same per-issuer limitation as applied to the 50 percent and 75 percent exclusion remains applicable to the 100 percent exclusion: for any one taxpayer the maximum amount of eligible gain with respect to the stock of a single issuer is the greater of $10 million or 10 times the taxpayer's basis in the stock of the issuing corporation.
The Section 1202 gain exclusion is claimed on the tax return filed for the year of the disposition of the QSBS stock. It is generally reported by (i) entering the entire gain realized on the sale in the long-term capital gains section of Schedule D, and (ii) entering "Section 1202 Exclusion" directly below the line on which you report the gain along with the amount of the allowable exclusion as a negative amount in column (a).
While it may not have been worth the effort to demonstrate stock qualification in the past, it may now make sense to seek the necessary information for qualification from companies.
What is QSBS?
In order for stock to qualify as QSBS, stock must meet the following two requirements:
(1) it must be stock (warrants do not themselves qualify but exercise of a warrant for stock is an acquisition) acquired at its original issuance for money, property (other than corporate stock) or services provided to the issuing corporation (provided the services are not as an underwriter of the stock). In the case of stock acquired for services, whether or not the 100 percent exclusion applies is generally based on the date the stock is issued and not necessarily when the services are performed. Note that certain redemptions of QSBS before or after the issuance of the stock may deprive the newly issued stock of QSBS status (see below).
(2) the corporation issuing the stock must be a qualified small business (QSB).
What Impact Do Redemptions Have on the Original Issuance Requirement?
Redemptions by the corporation from the taxpayer or a related person within the four-year period starting two years prior to the taxpayer's or related person's acquisition of the QSBS will disqualify the stock. Thus, the non-redemption period begins two years before and ends two years after the issuance of the stock to the taxpayer or related person. This is to encourage long-term investment. Additionally, "significant" redemptions by the QSB from shareholders (not just the taxpayer and his related persons) that occur within the two-year period starting one year prior to the acquisition of the QSBS ( i.e. , one year before until one year after that acquisition), will also disqualify the stock. The term "significant" redemptions means redemptions of more than 5 percent of the aggregate value of the QSB's stock. For these purposes, a redemption includes any transaction treated as a redemption pursuant to Code Section 304(a). It is at times difficult for companies to comply with these requirements as well as to produce the necessary information regarding stock ownership and stock transfers within the requisite four- or two-year period (a taxpayer should certainly know if stock has been redeemed from him, but may not always know whether stock has been redeemed from a related person or other shareholder). Minority stockholders often are not in a position to access the company's information. Up until this recent legislation, it has arguably not been worth the effort. Now, individual investors may want to negotiate covenants restricting disqualifying redemptions in their stockholder or investor rights agreements.
What is a QSB?
A QSB is a C corporation, the aggregate gross assets of which must not have exceeded $50 million at any time before the issuance of the stock to the applicable taxpayer or related person, as well as immediately after the issuance of the stock, and which satisfies the active business requirement. Any increase in the corporation's aggregate gross assets after this testing time (immediately after issuance) is not relevant.
The active business requirement is met if (1) the corporation uses at least 80 percent of its assets, measured by value, in the active conduct of one or more qualified trades or businesses, and (2) the corporation is an eligible corporation. A qualified trade or business generally does not include a service business, an oil and gas business, a banking or investing business, a motel business, or similar businesses. Start-up, R&D, and in-house research activities may be treated as used in an active trade or business, regardless of whether they have generated any gross income. Assets held for working capital needs may also be treated as used in the active conduct of a qualified business. There are limitations on the amount of portfolio stock and real estate that a corporation may hold and still be considered engaged in the active conduct of a qualified trade or business. An eligible corporation means a domestic corporation and does not include a DISC, RIC, REIT, REMIC or FASIT or a cooperative.
How Does Section 1202 Apply in the Partnership or Fund Context?
If a partnership disposes of QSB stock that it has held for more than five years, the gain from the disposition is allocated among all the partners, and the partners who held an interest in the partnership from the time it acquired the stock to the time it disposed of the stock are eligible for exclusion on their proportionate share of the partnership's gain. In determining a partner's proportionate share of the partnership's gain, the partner's ownership interest at the time the stock was acquired must be used. This requirement is meant to prevent taxpayers from increasing benefits under Section 1202 over time. However, it may not be clear how a partner's ownership interest is to be measured.
With respect to a fund that is closed, or whose investment period has expired, arguably all of its partners will have the appropriate holding period for the partnership interest. However, additional partners or partners who increase their interests may not enjoy the Code Section 1202 exclusion to the extent they were not partners at the time the partnership acquired its QSBS (or were not partners with respect to a portion of their interests in the partnership). What a partner's proportionate share is of the gain from the QSBS appears less clear, especially in a fund with a more complicated waterfall, and there are no Treasury regulations that offer guidance. In a plain-vanilla fund, a partner's percentage of the residual cash or profit should, arguably, represent its proportionate share. In a fund that provides its investors with a preferred return, allows for a general partner catch-up and has hurdles for different types of investors, the determination of proportionate share may be exceedingly complex.
Accordingly, the application of the proportionate share rule dictated in 1202 in connection with the substantial economic effect rule of Section 704(b), as well as the governing allocation provisions in a partnership agreement, may create confusion and uncertainty. Certain fund structures may allow for closer tracking of the QSBS ownership. At the very least, funds should, from a fiduciary standpoint, consider the issue and investors should consider whether their investment warrants a side letter provision addressing whether it should be considered or requiring efforts to take advantage of it. Investor protections may be negotiated in side letters that would require funds to seek agreement by potential portfolio companies to restrict redemptions in the appropriate time period after a stock acquisition by the fund. Of course, given that redemptions are disqualifying if made during the applicable time frame, the portfolio company stockholder list and the ultimate holders of the partnership interests may need to be compared. This could prove impossible to do (or perhaps inadvisable for confidentiality reasons) in cases in which, for example, a fund of funds (which may itself have partnerships invested in it) is an investor in the fund that buys the QSBS stock. Nonetheless, the Section 1202 considerations should not be tossed aside, but should be analyzed to determine whether they can be of benefit to non-corporate investors in the partnership or fund.
Julia D. Corelli, Partner, firstname.lastname@example.org
Julia D. Corelli is a partner in the Commercial Department of Pepper HamiltonLLP and co-chair of the firm's Fund Services Group.
Ms. Corelli has a transactional practice and concentrates in private investment fund formation, private equity investment transactions, venture capital investments, acquisitions and dispositions of business enterprises, joint ventures, and corporate/shareholder and partner/partner dealings. She also is experienced in matters of investment fund principal compensation and planning.
Laura D. Warren, Of Counsel, email@example.com
Laura D. Warren is of counsel in the Tax Practice Group of Pepper Hamilton LLP, resident in the Philadelphia office. Ms. Warren concentrates her practice in corporate and partnership federal tax planning with an emphasis in private equity investment, venture capital investment and hedge fund formation. Ms. Warren also advises on, acquisitions and dispositions of business enterprises, joint ventures, and partnership/partner dealings. She has experience in state and local tax issues, tax issues associated with charitable organizations, as well as corporate acquisitions.
Pepper Hamilton LLP
Pepper Hamilton LLP is a multi-practice law firm with more than 500 lawyers nationally. The firm provides corporate, litigation and regulatory legal services to leading businesses, governmental entities, nonprofit organizations and individuals throughout the nation and the world.
Pepper Hamilton's Funds Services Group counsels sponsors, managers, advisers and investors from all over the United States, and globally, regarding the complex structuring, operational, and regulatory challenges they face on a daily basis in the investment management business. Honed from representing hundreds of pooled investment vehicles over the course of more than two decades, our judgment and experiences enable us to help clients successfully navigate the legal landscape in which investment managers are required to operate.
Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances. For legal advice, please consult your personal lawyer or other appropriate professional. Reprinted with permission from Pepper Hamilton LLP.