Editor's Note: The Protecting Americans from Tax Hikes (PATH) Act of 2015 made permanent the special tax treatment for QSB stock acquired after September 27, 2010. The special treatment is now available for any QSB stock acquired after that date.

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 dog'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 eliminate your taxes, perhaps to a 0% rate on the gain.

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 early-stage employees, executives, and investors to hold securities they might otherwise have sold. When evaluating your stock position, consider whether you can take advantage of the following little-known tax provision to help defer or eliminate 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:

  • you bought or received your shares directly from a C-corporation (e.g. through the exercise of an option or the company's initial capitalization)
  • the corporation issued the stock after August 11, 1993, and had gross assets of $50 million or less prior to and immediately after issuance of the stock
  • the corporation meets an "active business" test and is not involved in certain types of business, such as banking, farming, hotels, and professional services (e.g. engineering or consulting)
Editor's Note: In TC Memo 2010-15, 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:

  • You must have held your original QSB stock for more than six months (not one year, as with long-term capital gains).
  • You must elect to apply the rollover provisions of Section 1045. You make the election on your income tax return for the tax year in which the original QSB stock is sold. (See Rev. Proc. 98-48.)

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.

Extra Benefits

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.

The 0% Rate And Its Complications: 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. An article in The New York Times emphasizes the need to seek guidance from experienced advisors: see How A Tax Loophole Is Helping Silicon Valley Workers Save Millions. Let's run through the basics so that when you meet your advisor you understand how these situations work.

How The 0% Rate Became Permanent

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 exclusion is the greater of either $10 million or 10 times the taxpayer's basis in the stock of the issuing corporation.

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). Afterwards, Congress extended the expiration date of this provision through several tax laws and, for the duration of the extensions, it excluded capital gains from being added to the alternative minimum tax (AMT) income calculation. The Protecting Americans from Tax Hikes (PATH) Act of 2015 made permanent the special tax treatment for qualified small business stock. Therefore, the special treatment is now available for any QSB stock acquired after September 27, 2010. For the potential impact of making this exclusion provision permanent, see an article in Accounting Today.

How To Qualify

Qualifying for the rate, however, is a bit more complicated than qualifying for rollover treatment of gains. Some of the requirements that must be met include:

  • You must have held the QSB stock for more than five years. If your basis in the QSB stock was determined as a result of a Section 1045 rollover, the holding period for purposes of Section 1202 includes the time during which those previous QSB shares were held.
  • Limitation on gain exclusion. For any one taxpayer, the maximum amount of eligible gain with respect to the stock of a single issuer that may be subject to the exclusion is the greater of either $10 million or 10 times the taxpayer's basis in the stock of the issuing corporation.
  • Effect of the alternative minimum tax (AMT). Even though this all may have started with nonqualified stock options or founder's stock, AMT can creep into it for QSB stock acquired prior to September 27, 2010. A portion of the gain excluded from gross income is added back to taxable income for the purpose of computing alternative minimum taxable income. To the extent you are subject to the AMT, the net effect will be to eliminate the reduced tax benefit.

An article in Investment News reports that, in a move sometimes called "stacking," owners of QSB stock can try to maximize the $10 million exclusion amount by gifting shares to separate non-grantor irrevocable trusts for the benefit of children or other family members. Each trust would then have its own $10 million gain exclusion. The authors point out that uncertainty lingers around this planning idea. They recommend consulting with tax advisors to obtain their opinions on the strategy.

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 37%) 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.

Donating And Gifting Stock

For QSB shareholders, while the standard advice for charitable giving is to donate highly appreciated stock, given the gain exclusion at sale it would be better to donate other shares held long-term. In addition, the QSB stock can be gifted during life or transferred at death. However, once an individual owns QSBS, those shares should not be contributed to a family partnership or family investment company (FIC) used to consolidate final investment activity for wealth-transfer purposes. This would disqualify the stock from QSBS treatment. For more details, see a commentary from Andersen Tax.

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.

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.