Techniques To Defer Or Reduce Taxes On The Sale Of Your Company's Shares (Part 1): QSB Stock
Editor's Note: For qualified small business stock (see the definition below) issued until the end of 2013, 100% of the gains will be excludable from capital gains tax (0% rate) and omitted from the AMT calculation. The American Taxpayer Relief Act of 2012 made this provision retroactive and extended it. In 2014, the exclusion returned to its usual level of 50% (14% tax rate), and excluded capital gains returned to being part of the AMT calculation.
Finding legal techniques to minimize taxes is almost as popular in the USA as stock compensation. Tax advisors can evaluate sophisticated techniques for reducing, or at least deferring, the tax man's bite.
Your situation may be like the following. You've exercised your stock options and are holding on to the stock. Alternatively, you may have bought the stock from the company as an employee or a founder before it went public. Your company's stock performance has made you wealthy on paper, but because of a large concentration in company stock, you may find that you are no longer sufficiently diversified.
QSB stock can help you defer or reduce your taxes.
Like many individuals who experience volatility in the stock market, you closely monitor your portfolio. You are considering making changes to your investments but are concerned about taxes.
Quick Tax Review
Most securities held over one year qualify for the preferential rate on capital gains. While this rate is lower than the rate on ordinary income, the tax can still be substantial. This potential tax has caused some investors to hold securities they might otherwise have sold. When evaluating your investment position, consider whether you can take advantage of the following little-known tax provision to help defer or reduce your taxes.
Qualified Small Business Stock
After AOL bought out Netscape, Marc Andreessen, a founder of Netscape and now a venture capitalist, sold $5.7 million of AOL stock to finance his stake in his next company, and "he didn't pay a penny in capital gains taxes," according to Forbes magazine. If you have qualified small business (QSB) stock, you may be able to follow his example.
Detailed rules govern whether your stock is QSB stock. Generally, your stock may qualify if:
Editor's Note: In TC Memo 2010-15 (Feb. 2010), the US Tax Court provides an example of how strictly the QSB stock requirements are interpreted. If you hold employee stock options in a small business and they are converted into options and then stock in a larger acquiring public company, you may not be allowed to use the benefits of this provision.
How You Defer Paying Tax On Sale Of QSB Stock: Roll Over Gains
The deferral is available only to the extent that you would have had capital gain on the sale.
Section 1045 of the Internal Revenue Code (IRC) allows you to sell your QSB stock and defer paying any tax on the gain if you reinvest the proceeds into new QSB stock within 60 days from the date of sale. To qualify, you must meet a number of conditions.
Two of the significant requirements are:
Any sale proceeds you keep are taxed at regular rates. The deferral is available only to the extent that you would have had capital gain on the sale. So if the sale involves a disqualifying disposition of ISO stock, only the post-exercise appreciation can be deferred; any ordinary income is still recognized.
Also analyze the state-tax impact of QSBS.
One of the nice things about this provision is that no limits exist on how much you can roll over or how many times you can elect rollover treatment. Another benefit is that the replacement stock doesn't have to be stock of only one company: you can roll over the proceeds into a diversified portfolio of QSBs and still defer the gain.
You should keep in mind, however, that while the tax has been deferred, it has not been eliminated. The basis of your old shares is "carried over" into your new shares. Unless you hold the new shares until death or give the property to charity, a tax will be due should you sell your QSB shares and not qualify for further rollover. Even so, the tax law may provide an additional benefit when you sell QSB shares.
Complications And The 0% Rate: You Sell QSB Shares Without Another Rollover
The next two situations make QSB stock more complex, and in these cases it is definitely time to call in an accountant, financial planner, or tax lawyer familiar with this provision. I'll run through the basics so that when you meet your advisor (or try to impress your friends!) you understand how these situations work.
Congress, in an effort to spur investment in small businesses, enacted Section 1202 of the IRC, which provided a 50% gain exclusion under the 1993 tax rates (the capital gains rate was 28% in 1993). For taxpayers in the 25% tax bracket or above, the enactment of Section 1202 reduced the tax rate on sales of certain QSB stock to 14%, which seemed a good deal when the long-term capital gains rates were 28% in 1993.
The Small Business Jobs & Credit Act of 2010 provided that for qualified small business stock issued between September 27, 2010, and the end of 2010, the exclusion was 100% (i.e. 0% tax on the capital gains). The expiration date of this provision was extended until the end of 2011 by the 2010 Tax Relief Act. Also, for the duration of that temporary measure, excluded capital gains were also temporarily omitted from the alternative minimum tax (AMT) calculation.
Alert: The American Taxpayer Relief Act of 2012 made retroactive to the beginning of 2012 this 100% exclusion for gain realized from the sale of "qualified small business stock" (QSB stock). Therefore, special treatment under Section 1202 of the Internal Revenue Code is now available to any QSB stock acquired between September 27, 2010, and December 31, 2013. Unless the provision is extended, as of January 1, 2014, the exclusion will be limited to 50% of eligible gain, and a portion of the gain will again be required to be included in income for alternative minimum tax purposes. For more details on the extension through 2013, see memos from the law firms Morgan Lewis and Orrick. See also an article on this topic in The Tax Adviser (Qualified Small Business Stock: An Opportunity for Tech Startups).
Qualifying for the rate, however, is a bit more complicated than qualifying for rollover treatment of gains. In addition, the reductions in capital gains rates since 1993 have reduced interest in qualifying for the rate. Some of the requirements that must be met include:
You Sell Your QSB Shares At A Loss
The tax law may offer a special benefit if you sell QSB shares at a loss.
No one wants to sell shares at a loss, and until recently no one thought they might have to, but even in this instance the tax law may offer a special benefit if you sell QSB shares at a loss. For most types of capital assets held over one year, any loss recognized on sale is considered to be a long-term capital loss, which is deductible only against capital gain (except for up to $3,000, which can be used to offset ordinary income).
Ordinary losses, by contrast, are deductible in full against ordinary income. Since ordinary income is often subject to a much higher tax rate (up to 35%) than capital gains, ordinary losses usually generate much greater tax savings.
If your QSB shares satisfy the requirements of IRC Section 1244 as "small business stock," up to $100,000 each year on a joint return of what would otherwise be capital loss may be treated as an ordinary loss. If, after applying the limitation, the ordinary loss exceeds your net income for the year, the excess is even available to offset income from prior and future years. The loss on the stock can be caused by a sale or the company's liquidation, or if the shares become worthless.
Editor's Note: You also need to analyze the state-tax impact of QSB stock. California, for example, has adopted its own variations of the rollover and gain-exclusion provisions. According to The M&A Tax Report, a Californian tax official told the editor that "every California return with QSBS on it gets audited." The publication's June 2007 issue adds:
"If replacement stock is purchased within 60 days of the sale of the QSBS, but the taxpayer fails to label the replacement stock on the taxpayer's income tax return, California auditors will generally disallow rollover treatment and refuse to permit the taxpayer to file an amended return correcting the election."
The only exception, the publication adds, occurs if an incorrect sale date is referenced.
In October 2007 the IRS issued final regulations (TD 9353 in IRB 2007-40) that provide guidance on applying QSBS rules to partnerships (and their partners) that hold the stock. See an article in Financial Planning for additional details on the use of this tax code provision for investing and minimizing taxes on stock in startup companies.
Part 2 looks at another way to defer tax by investing your gains in specialized small business investment companies (SSBICs).
The author is a former partner of a major accounting firm, where he was the National Director of Personal Income Tax and Retirement Planning. This article was published solely for its content and quality. Neither the author nor his former firm compensated us in exchange for its publication.