Tax Benefits of Owning Small Business Stock – A Neglected Opportunity
Berdon Tax Team
07.26.2016 | Client Alert
One of the unheralded tax provisions of the Protecting Americans from Tax Hikes Act of 2015 (PATH Act) was the reinstatement of the 100% exclusion of gain from the sale or exchange of small business stock. This Alert discusses the tax benefits of owning small business stock, which have been woefully neglected by tax advisors and taxpayers alike.
Individuals and other non-corporate taxpayers are entitled to exclude up to 100% of the gain from the sale or exchange of small business stock if the requirements described below are met. These taxpayers are entitled to elect to defer some or all of the gain (where a full exclusion is not available) by reinvesting the proceeds in new small business stock. The exclusion and rollover provisions only apply to stock held in corporations in certain industries such as manufacturing, retail, wholesale, and technology.
Individuals, but not other taxpayers, are entitled to treat a loss from the sale or exchange of small business stock as an ordinary loss -subject to limitations. The ordinary loss provisions are not limited to specific industries.
Under Section 1202, individuals and other non-corporate taxpayers may exclude 100% of the gain, subject to limitations, from the sale or exchange of small business stock acquired after September 27, 2010. For stock that was acquired on or before that date, but after August 10, 1993, a lesser exclusion of 50-75% is available. The remaining gain is taxed at a 28% rate, plus a potential 3.8% tax on net investment income.
The exclusion is available if:
1. The taxpayer is the original purchaser of the stock from the corporation including through an underwriter,
2. The consideration for the small business stock was cash, property other than stock, or services provided to the corporation, and
3. The taxpayer held the small business stock for more than five years.
The exclusion is not available if the corporation enters into significant redemptions of stock during a specified period before or after the date the stock was issued to the taxpayer.
The amount of gain that is eligible for exclusion is limited to the greater of (i) $10 million ($5 million for married filing separate taxpayers) per corporate issuer, or (ii) ten times the adjusted basis of the stock disposed of during the taxable year ignoring additions to basis after the date of original issue. The amount of gain that exceeds the limitation is generally subject to tax at rates that apply to long-term capital gains -15% or 20%, plus a potential 3.8% tax on net investment income.
However, taxpayers have the ability to defer the potential tax on Section 1202 gain that exceeds the per-issuer limitation by reinvesting some of the proceeds in new small business stock and making the Section 1045 election described below.
Stock is generally considered to be small business stock eligible for exclusion if it is issued by a domestic C corporation that has aggregate gross assets of $50 million or less at all times from formation until immediately after the issuance to the taxpayer. In determining whether the gross assets of the C corporation are appropriate, the gross assets of related corporations are taken into account. It should be noted that the size of the corporation at the time of sale of the stock is irrelevant in determining whether the stock is small business stock.
An additional requirement is that the corporation must be engaged in the active conduct of a trade or business and be treated as a domestic C corporation for substantially all of the taxpayer’s holding period. In addition, at least 80% of the assets of the corporation (by value) must be used in the active trade or business. For this purpose, start-up and research activities for a future active trade or business are treated as the active conduct of a trade or business even if corporation does not have any gross income.
Certain trades or businesses are excluded from consideration for the active trade or business requirement. They are:
- Professional service organizations (healthcare, law, architecture, accounting, and consulting),
- Any trade or business where the principal asset is the reputation or skill of one or more employees,
- Any financial business (banking, insurance, financing, leasing, or investing),
- Any farming business,
- Any business involving the production or extraction of oil, gas, minerals, rock, or metal,
The business or operation of a hotel, motel, restaurant, or similar business: and
The ownership of, dealing in, or renting of real property.
Corporations that actively conduct a manufacturing, retail, wholesale, or technology business will generally be able to meet the active trade or business requirement.
The exclusion provisions can apply if a partnership or other pass-through entity sells small business stock and the gain is allocated to an individual or other non-corporate taxpayer. For a partner or other equity holder in a pass-through entity to qualify for the exclusion, the taxpayer must have owned an equity interest in the entity from the date the entity acquired the small business stock to the date the entity disposed of the stock.
Section 1045: A further tax benefit of owning small business stock is that taxpayers are permitted to roll over the gain from the sale. The rollover provisions only apply if the taxpayer has owned the small business stock for more than six months and some or all of the gain would otherwise have been eligible for exclusion under Section 1202.
After the sale of stock at a gain, the taxpayer can reduce the taxable gain by reinvesting some or all of the proceeds in small business stock in a different corporation within sixty days of the sale. This rollover provision is ideal for taxpayers that have held small business stock for more than six months but five years or less. The rollover provisions cannot be used to reduce the taxable gain to the extent the gain is ordinary income (e.g., sales by dealers).
The rollover provisions can apply if a partnership sells small business stock. The partnership can elect to defer the gain and invest the proceeds in new property. A partner can opt out of the election by the partnership. In addition, a partner can elect to defer gain recognized by a partnership and invest the proceeds in new property. It should be noted that the rollover provisions do not apply if a partner disposes of a partnership interest at a gain even if the underlying partnership owns small business stock.
Section 1244. Individuals are entitled to treat the loss, subject to limitations, under Section 1244 from the sale or exchange of small business stock as an ordinary loss if the loss would otherwise be treated as a capital loss. The amount of the loss that is eligible for ordinary treatment is limited to $50,000 (or $100,000 in the case of taxpayers filing a joint return) per taxable year.
Ordinary loss treatment is available if (i) the taxpayer is the original purchaser of the stock from the corporation, (ii) the stock is common stock, voting or non-voting, and (iii) the consideration for the small business stock was cash or property other than stock or securities.
Common stock is generally considered to be small business stock that is eligible for ordinary loss treatment if it is issued by a domestic C corporation (i.e., not an S corporation) and the aggregate amount of money and property received by the corporation for equity (including capital contributions) is less than $1 million. The corporation can designate which shares qualify for ordinary treatment with respect to shares that are issued in the first taxable year in which the aggregate money or property received equals or exceeds $1 million.
An additional requirement for ordinary loss treatment is that the corporation must have derived more than 50% of its aggregate gross receipts from active sources other than from royalties, rents, dividends, interest, annuities, and gains from the sale or exchange of stock or securities during the five most recent taxable years. It can be a shorter period, if the corporation was not in existence for five taxable years ending before the loss is incurred. The requirement for active gross receipts does not apply if the corporation had a net loss, (deductions exceed gross income) for the five taxable years or shorter period.
It should be noted that the requirements for small business stock treatment under Section 1244 (ordinary loss) are different from the requirements under Sections 1202 (exclusion) and 1045 (rollover). It is possible that stock can qualify for one provision and not the other.
Ordinary loss treatment can apply if a partnership disposes of small business stock and the loss is allocated to an individual. For a partner in a partnership to qualify for ordinary treatment, that individual must have owned a partnership interest on the date it acquired the small business stock.
If you have questions about these or other provisions, contact your Berdon advisor. Berdon LLP, New York Accountants