The Tax Increase Prevention Act (“TIPA”), enacted on December 19, 2014, retroactively extends several tax incentives that expired at the end of 2013. Among the key features of TIPA is a provision extending benefits to eligible investors in Qualified Small Businesses.
Originally enacted in 1993, Internal Revenue Code Section 1202, which covers the Qualified Small Business rules, was intended to encourage investment in small businesses by providing a 50% exclusion of gain resulting from the sale of a qualified small business stock (“QSBS”) held for more than five years. In order to qualify, the corporation must use at least 80% of the value of its assets in an active conduct of a qualified trade or business, and its aggregate gross assets cannot exceed $50 million after the stock is issued.
In 2010, this Code Section was amended to provide a temporary 100% gain exclusion for QSBS acquired after September 27, 2010. Through subsequent legislation, including the recently enacted TIPA of 2014, the exclusion has been extended for QSBS acquired through December 31, 2014. However, the 2010 amendments did more than just raise the exclusion to 100%; they also eliminated the excluded gain as a preference item, meaning that the excluded gain is no longer subject to the Alternative Minimum Tax.
Related provisions of the Internal Revenue Code also allow non-corporate taxpayers who acquired and hold qualified small business stocks for more than six months to elect to defer realized gain upon the sale of the QSBS by reinvesting the sale proceeds, within 60 days, into new QSBS. The taxpayer’s basis in the new QSBS is reduced by the amount of deferred gain. These deferral provisions were not affected by Tax Increase Prevention Act.
Beginning in 2013, the maximum capital gains rate increased to 20%, and the new net investment income tax [“NII”] tax of 3.8% is now applied to investment income, including gains from the sale of stock. However, gain that is exempt from tax under QSBS rules would also be exempt from the 3.8% NII tax. As such, the recent increases to the exclusion amount under QSBS, coupled with the significant increase in tax rates on investment income, have combined to make this exclusion an attractive tax incentive for investors in qualified small businesses.
QSBS tax incentives provide an attractive motivation for
- Investors to acquire stock in qualifying ventures, and
- Entrepreneurs to consider organizing their ventures as C Corporations. This incentive provides an opportunity for qualified small businesses to operate as a corporation without the double taxation inherent in C-Corp disposition.
The extension of the federal 100% gain exclusion is a welcome development, although the qualified small business stock rules are complicated and, in several critical places, vague. The election to be considered a QSBS is included with the Company’s organization documents and is not a separately filed tax election. Those investors looking to create or invest in such an entity should be aware of this rule and review company bylaws prior to investing.
With the increase in maximum long-term capital gains tax rates and the introduction of the 3.8% Medicare tax, the qualified small business stock gain exclusion and deferral provisions are increasingly attractive propositions for eligible investors.
Contact your Marcum Tax Advisor for addition questions on this type of investment.