Turning startup profits into 100% tax-free gains.

(My apologies for the technical nature of this article. Perhaps it is best to just print it out and give it to the accountant or lawyer. However, it could be worth a great deal of money and there are a number of ways to really mess it up. MK)<p>Venture capitalists and private equity groups are reportedly taking an interest in structuring startups to qualify under the qualified small business stock (QSBS) provisions of Code Sec. 1202. It's not hard to see why — this often-overlooked Code provision can turn much or all of the profit on a successful investment in a startup into tax-free gain. But time may be of the essence: Under current law, the 100% exclusion won't apply for QSBS acquired after 2011. This Practice Alert provides an overview of the principal rules and opportunities.<p>Overview. Noncorporate taxpayers may exclude from gross income 100% of any gain realized on the sale or exchange of QSBS held for more than five years if the QSBS is acquired after Sept. 27, 2010 and before Jan. 1, 2012. The exclusion is 75% of gain realized on the sale or exchange of QSBS acquired after Feb. 17, 2009 and before Sept. 28, 2010, and 50% of gain realized on the sale or exchange of QSBS acquired either before Feb. 18, 2009, or after Dec. 31, 2011 (but 60% instead of 50% for certain gain attributable to QSBS in a qualified business entity). Excluded gain is subject to a cumulative and annual dollar limitation. (Code Sec. 1202(a)(4), Code Sec. 1202(b)(1), Code Sec. 1202(b)(2))<p>Additionally, the alternative minimum tax (AMT) preference for a portion of gain from the sale or exchange of QSBS that is excluded from gross income for regular tax purposes under Code Sec. 1202 doesn't apply to QSBS acquired after Sept. 27, 2010 and before Jan. 1, 2012. (Code Sec. 1202(a)(4)(C))<p>A noncorporate taxpayer's net capital gain that is adjusted net capital gain is taxed at a maximum rate of 15%. If the adjusted net capital gain would otherwise be taxed at a rate below 25% if it were ordinary income, it is taxed at a zero percent rate. (Code Sec. 1(h)(1)(B), Code Sec. 1(h)(1)(C)) Under current law, these rates are in effect through 2012. Net capital gain attributable to section 1202 gain (as well as collectibles gain) is taxed at a maximum rate of 28%. (Code Sec. 1(h)(1)(E), Code Sec. 1(h)(4)) Section 1202 gain is the excess of (1) the gain that would be excluded from gross income on the sale of certain QSBS under Code Sec. 1202, if the percentage limitations of Code Sec. 1202(a) didn't apply, over (2) the gain actually excluded under Code Sec. 1202. (Code Sec. 1(h)(7))<p>Qualifying as QSBS. Stock qualifies as QSBS only if it meets all of the following tests. (Code Sec. 1202(c), Code Sec. 1202(d))<p>(1) It must be stock in a C corporation (that is, not S corporation stock) originally issued after Aug. 10, '93.<p>(2) As of the date the stock was issued, the corporation was a domestic C corporation with total gross assets of $50 million or less (a) at all times after Aug. 9, '93, and before the stock was issued, and (b) immediately after the stock was issued. Gross assets include those of any predecessor of the corporation, and all corporations that are members of the same parent-subsidiary controlled group are treated as one corporation.<p><pre><code> Observation: The company must be relatively small when it begins life but if all the conditions are met, the Code Sec. 1202 exclusion is available no matter how large it grows. </code></pre> (3) In general, the taxpayer must have acquired the stock at its original issue (either directly or through an underwriter), either in exchange for money or other property or as pay for services (other than as an underwriter) to the corporation.<p>(4) During substantially all the time the taxpayer held the stock:<p>· The corporation was a C corporation;<p>· At least 80% of the value of the corporation's assets were used in the active conduct of one or more qualified businesses; and<p>· The corporation was not a foreign corporation, domestic international sales corporation (DISC), former DISC, regulated investment company (RIC), real estate investment trust (REIT), real estate mortgage investment conduit (REMIC), financial asset securitization investment trust (FASIT), cooperative, or a corporation that has made (or that has a subsidiary that has made) a Code Sec. 936 election.<p><pre><code> Caution: It is reasonably common for startup businesses to initially elect to be S corporations, principally so that they can pass through to their shareholders losses that they anticipate incurring in their early years of operation. However, the decision to make that election should be reexamined if the shareholders anticipate taking advantage of the QSBS gain exclusion; if the S election results in the corporation not being a C corporation during “substantially all” of a given shareholder's holding period for the stock, the QSBS gain exclusion won't be available to that shareholder. Unfortunately, neither Congress nor IRS has given any indication as to what will be considered “substantially all” of a shareholder's holding period for this purpose.

        Active conduct of a qualified business. For purposes of the rule requiring 80% of the value of assets to be used in the conduct of a qualified business, all of the following are treated as used in the active conduct of a qualified business:

</code></pre> A. Assets used in certain activities with respect to future qualified businesses, without regard to whether the corporation has any gross income from these activities at the time this rule is applied. Those activities are (a) Code Sec. 195(c)(1)(A) startup activities, (b) activities that result in the payment or incurrence of qualifying research and experimental expenditures under Code Sec. 174, and (c) activities with respect to in-house research expenses. (Code Sec. 1202(e)(2))<p>B. Assets held to meet the reasonably required working capital needs of a qualifying business, and assets held for investment that are reasonably expected to be used within two years to finance research and experimentation in a qualified business or to finance increases in working capital needs of such a business. (Code Sec. 1202(e)(6)) But, after the corporation has been in existence for at least two years, no more than 50% of its assets may qualify as being used in the active conduct of a qualified business by reason of these rules. (Code Sec. 1202(e)(6))<p><pre><code> Observation: Under Reg. § 1.537-2(b)(4), earnings and profits accumulated “to provide necessary working capital” for a business are not subject to the accumulated earnings tax. The Bardahl formula has been applied to calculate “necessary working capital.” Although neither Congress nor IRS has indicated that these rules have application for Code Sec. 1202 purposes, it would appear that the reg and other rules that have been developed to interpret the reg, including the Bardahl formula, have application for purposes of computing “reasonably required working capital needs.” </code></pre> C. The rights to computer software which produces active business computer software royalties as defined in Code Sec. 543(d)(1). (Code Sec. 1202(e)(8))<p><pre><code> A corporation will be treated as failing to meet the active business requirement for any period during which: (1) more than 10% of the value of its assets in excess of its liabilities consists of stock or securities in other corporations which are not subsidiaries of the corporation, other than working capital assets; or (2) more than 10% of the total value of its assets consists of real property which is not used in the active conduct of a qualified business (for this purpose, owning, dealing in, or renting real property is not considered to be the active conduct of a qualified business). (Code Sec. 1202(e)(5)(B), Code Sec. 1202(e)(7))

        Note that a corporation will be treated as meeting the active business requirement for any period during which it is a specialized small business investment company (SSBIC). (Code Sec. 1202(c)(2)(B)(i))

        Qualified business. For QSBS purposes, a qualified business is one that isn't:

</code></pre> · A business involving services performed in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services.<p><pre><code> Observation: Note that the rule in the first bullet is limited to service businesses, while the rule in the second, below, is not so limited. </code></pre> · A business whose principal asset is the reputation or skill of one or more employees.<p><pre><code> Observation: There is no other instance in which either the Code or the regs use the term “principal asset” in the context of an intangible human quality like “reputation” or “skill.” And, the relevant Congressional Committee reports do not add any insight as to Congress' intent with respect to this language. Thus, it is quite unclear which trades or businesses will fail the qualified business test as a result of this language, or which more-specific characteristics of any given trade or business are indicative of it failing this test. </code></pre> · A banking, insurance, financing, leasing, investing, or similar business.<p>· A farming business (including the raising or harvesting of trees).<p>· A business involving the production of products for which percentage depletion can be claimed.<p>· A business of operating a hotel, motel, restaurant, or similar business.<p><pre><code> Dollar limit on eligible gain. For each tax year, for each corporation in which the taxpayer sells or exchanges QSBS, the amount of gain eligible for the exclusion can't exceed the greater of: </code></pre> (1) $10 million ($5 million for married persons filing separately), less the total amount of eligible gain (i.e., gain on the sale or exchange of QSBS held for more than five years) taken into account under the Code Sec. 1202(a) rules by the taxpayer with respect to dispositions of stock issued by the corporation in all earlier tax years, or<p>(2) ten times the taxpayer's total adjusted basis in QSBS of the corporation disposed of by the taxpayer in the tax year. (Code Sec. 1202(b)(1))<p><pre><code> Illustration 1: Larson, a single taxpayer, acquired 10,000 shares of QSBS in Corp A on Nov. 15, 2010 at $10 per share, for a total cost of $100,000. This is the only QSBS he has ever owned. Larson sells all 10,000 Corp A shares in 2017 for $20.1 million ($2,010 per share). The maximum gain eligible for exclusion is the greater of (1) $10 million; or (2) $1 million, i.e., 10 times his $100,000 total basis in the 10,000 shares. Thus, on his 2017 individual return, Larson can exclude $10 million of the gain.

                Observation: The balance of Larson's gain would, under current rules, be taxed at a maximum rate of 15%. The $10 million excess over the excluded gain of $10 million is not treated as section 1202 gain subject to the 28% rate under Code Sec. 1(h)(7), because the current 100% percentage limitation under Code Sec. 1202 does not affect the amount excludible. Rather, the exclusion is capped by the dollar limitation of Code Sec. 1202(b)(1). This result is supported by an example at page 149 of the Committee Reports to P.L. 105-206 (the Internal Revenue Service Restructuring and Reform Act of 1998 ('98 RRA).

               Observation: The limit in (1) is expressed as a dollar cap of $10 million ($5 million for separate filers) and also is a cumulative cap with respect to dispositions of stock of the same corporation. By contrast, the limit in (2) does not have a dollar cap—instead, the limit is based on the basis in the QSBS shares—and is an annual limit. Thus, by stretching out sales of QSBS of the same corporation, a taxpayer may be able to exclude more than $10 million of gain.

             Illustration 2: Anderson, a single taxpayer, acquired 10,000 shares of QSBS in Corp B on Dec. 15, 2010 at $500 per share, for a total cost of $5 million. This is the only QSBS he has ever owned. Anderson sells 5,000 Corp B shares in 2017 for $12.5 million ($2,500 per share). His entire profit of $10 million ($12.5 million minus $2.5 million cost) is excluded. In 2018, Anderson sells his 2,500 remaining Corp B shares for $12.5 million. His $10 million profit for 2018 also will be excluded. The maximum gain eligible for exclusion for 2018 is the greater of: (1) zero ($10 million less the $10 million he excluded in 2017); or (2) $25 million, i.e., 10 times his $2.5 million basis in the 5,000 shares he sells in 2018.

                Observation: Obviously an investor in Anderson's situation would spread out sales only if he thought his QSBS shares would remain at the same price or appreciate in value.

        Other rules. The complex QSBS requirements include anti-abuse provisions (Code Sec. 1202(c)(3)), special rules for taxpayers or related parties that take certain short positions in the stock (Code Sec. 1202(j)), stock held by passthroughs (Code Sec. 1202(g)), and gifts and bequests (Code Sec. 1202(h)).</code></pre>