Qsbs stock options

Qualified Small Business Stock (QSBS) Gains – FAQs.

October 7, 2013 update on QSBS gains.

AB 1412 (Stats. 2013, ch. 546), signed by the Governor on October 4, 2013, retroactively allows the Qualified Small Business Stock (QSBS) deferral and 50 percent gain exclusion for tax years 2008 to 2012.

Although AB 1412 is effective January 1, 2014, FTB is providing the following information for taxpayers impacted by amendments made by AB 1412 to Revenue & Taxation Code Sections 18038.5, 18152.5, and 18153, Frank Cutler v. Franchise Tax Board , (2012) 208 Cal. App.4th 1247, or Franchise Tax Board Notice 2012-03.

Taxpayers who have not filed their 2012 tax return.

Taxpayers who are entitled to the retroactive QSBS provisions may claim the exclusion or deferral. To claim the exclusion or deferral for QSBS on Form 540 Schedule D, report the entire amount of gain from the sale of QSBS. Immediately underneath that line write “QSBS exclusion” and report the exclusion amount as a negative number (loss), or write “QSBS deferral” and report the deferral amount as a negative number (loss). Taxpayers claiming the exclusion should report 50 percent of the QSBS exclusion amount on Form 540 Schedule P, Line 10, Incentive stock options and California qualified stock options, as an alternative minimum tax (AMT) preference item.

Taxpayers who filed their 2008 – 2012 tax returns and were contacted by the FTB regarding their QSBS election.

FTB will notify taxpayers of the following:

Pending Notices of Proposed Assessments based on the Cutler decision or FTB Notice 2012-3 will be withdrawn. Closing letters will be mailed to taxpayers who signed a limited QSBS waiver for 2008. Unpaid tax, interest, or penalty assessed as a result of the Cutler decision/FTB Notice 2012-3 will be abated. Refunds for payments received related to the Cutler decision/FTB Notice 2012-3 will be issued. No action is needed by taxpayers to request refunds, unless they do not hear from the FTB by November 30, 2013. In these circumstances, taxpayers may contact the FTB at 916.845.3030.

Taxpayers who filed their 2008 – 2012 tax returns and did not claim the QSBS election may now do so.

AB 1412 modifies the current QSBS statutes (Revenue and Taxation Code Section 18038.5, 18152.5) and eliminates the previous requirement that 80 percent of business activity occur in California during the holding period. However, the QSB must meet the 80 percent California payroll requirement at the time of acquisition for taxpayers to claim the 50 percent gain exclusion or deferral on an amended return (claim for refund) if the statute of limitations is open. Generally, the statute of limitations is four years from the date the return was filed (if filed within the extension period), or one year from the date of the overpayment, whichever is later. In addition, newly enacted Revenue and Taxation Code section 18135 allows taxpayers until June 30, 2014, to file a QSBS claim for refund for tax year 2008. See information entitled “Taxpayers who have not filed their 2012 return” above for instructions about how to claim the exclusion or deferral.

Amended returns should state in red “ QSBS CLAIM FOR REFUND ” at the top of the return, include the computed refund amount, and be mailed to the following address:

Cutler Claim for Refund 347 MS F381.

Franchise Tax Board.

C/O FTB Notice 2012-03.

Rancho Cordova, CA 95741-1779.

Courier Service Delivery or Private Courier Mail:

Franchise Tax Board.

Sacramento, CA 95827.

FTB Notice 2012-3’s guidelines still apply to tax years 2007 and prior, with an open statute.

The governor signed Assembly Bill 1412 on October 4, 2013. This allows taxpayers to report QSBS exclusions and deferrals of gain for 2008-2012 tax years.

The information below is for historical purposes.

Background.

Federal income tax law provides for the exclusion or deferral of gain from the sale or exchange of qualified small business stock (QSBS). Beginning in 1993, California adopted its own standalone QSBS provisions dealing with exclusions, which generally mirrored existing federal law. However, California law required that at least 80 percent of the company's payroll at the time the stock was purchased must be within California and 80 percent of assets and payroll must be within California during the taxpayer's holding period for the stock in order to qualify for a QSBS gain exclusion or deferral. In 1998, California adopted its own standalone QSBS provision dealing with deferrals.

The provisions in California law regarding the 80 percent asset and payroll requirements were found to be unconstitutional in August 2012 by the California Court of Appeal in Cutler v. Franchise Tax Board (FTB). The court's decision made California's entire QSBS statute invalid and unenforceable. As a result, all QSBS gain exclusions and deferrals previously allowed under California law became invalid. It is important to note that the court's decision in Cutler did not change the federal treatment of QSBS.

Because QSBS gain exclusions and deferrals are no longer valid for California purposes, taxpayers who previously took advantage of California's preferential treatment of QSBS in years still open for assessment under the four-year statute of limitations (generally 2008 and later) must now recompute their taxable income for each affected year without excluding or deferring gains from the disposition of QSBS. For 2007 (and prior) tax years still open under the statute of limitations, a QSBS gain exclusion or deferral will be allowed if the taxpayer meets all other requirements under California law, i. e., those other than the 80 percent asset and payroll requirements (See FTB Notice 2012-03).

General questions.

This notice affects taxpayers who excluded or deferred gain from the sale of QSBS under California Revenue and Taxation Code (R&TC) Sections 18152.5 or 18038.5. If you claimed an exclusion or deferral for taxable years beginning January 1, 2008 or later, then those items must be corrected. For taxable years beginning prior to January 1, 2008, and earlier, some taxpayers may be entitled to file claims for refund.

Your federal QSBS exclusions and/or deferrals are not affected by the Cutler decision or FTB Notice 2012-03.

For taxable years beginning January 1, 2008, or later, you should file amended tax returns for the years in which the exclusions or deferrals were reported. If you don't file amended tax returns, you can expect to be contacted by FTB. Also see interest and penalties FAQ 4 regarding the implications of interest suspension and a possible alternative to filing an amended return to report the corrections.

Review your returns and determine if you reported a QSBS gain exclusion or deferral. If there was no exclusion or deferral reported on your tax return, please contact us. We will review your return and take appropriate action.

After the court found the statute was unconstitutional, the FTB carefully considered every administrative option possible. We found no lawful option for the FTB but to strike the provisions for tax years within the statute of limitations. The court found that the statute improperly discriminates against interstate commerce, which is a situation which must be remedied. The FTB has had to deal with statutes found to improperly discriminate against interstate commerce in the past and addressed such discrimination through a remedy which was substantially similar to the remedy described in Legal Notice 2012-03. The propriety of that remedy has been litigated and upheld by the California Court of Appeal.

Legislative Intent is Clear and Cannot be Altered by Administrative Action – The Legislature’s creation of this tax benefit was intended to spur investment in California. The Legislature never intended to confer the QSBS benefits on all taxpayers, but rather clearly and unambiguously designed the provisions to favor investment in California businesses.

Because the California Constitution expressly and exclusively vests the Legislature with lawmaking authority, modifying a legislative enactment so as to write a new law is beyond any administrative agency’s power, including the FTB’s.

While the FTB has no discretion to administratively provide relief, the Legislature is not similarly constrained. The Legislature may wish to consider corrective actions to provide relief to adversely impacted taxpayers.

Interest and penalties.

Are there any penalties that I might be subject to as a result of the Cutler decision?

Generally there will not be penalties assessed due to the correction of a reported gain exclusion or deferral relating to QSBS under the notice. However, if your original return was not filed timely, there may be a penalty for filing a delinquent return, which will be based on the additional tax due. Also see interest and penalties FAQ 5.

Interest will accrue on a balance due as prescribed by California law. (See R&TC Section 19101.) The imposition of interest is mandatory, and FTB is not allowed to abate interest except where authorized by law ( Appeal of Amy M. Yamachi , 77-SBE-095, June 28, 1977.).

Generally neither interest abatement nor interest suspension will be available.

Interest abatement — Under R&TC Section 19104, interest may be abated only in limited circumstances where a delay was caused by an unreasonable error or delay by FTB in performing a ministerial or managerial act. A change in law due to a California Court of Appeals decision is not a managerial or ministerial act by FTB.

Interest suspension — Under R&TC Section 19116, interest may be suspended where a proposed deficiency notice is not issued within 36 months of the original due date of the return or the date the original or amended return was filed, whichever is later. FTB will automatically compute any applicable interest suspension amount on a proposed deficiency assessment. As explained below, because the due date of the 2008 return is more than 36 months ago, it may be to some taxpayers’ advantage for FTB to make the adjustment by Notice of Proposed Assessment (NPA) rather than by the taxpayer filing an amended return.

Because of the way the interest suspension rules under R&TC Section 19116 operate, if more than 36 months have elapsed since you timely filed your 2008 return, and you now file an amended return including the full amount of the gain previously excluded under R&TC Section 18152.5 or deferred under R&TC Section 18038.5, no interest suspension would be allowed by law.

Instead, to qualify for interest suspension for 2008, you may compute the additional tax due (or contact us for help in computing the additional tax due) and pay this amount as a tax deposit without filing an amended return. The amount paid will be applied against the tax liability shown on the notice of proposed assessment (NPA) that we will issue for 2008. Interest suspension will then apply to the periods after the expiration of 36 months from the date the original return was filed and the date that the FTB issues its NPA ( Note: Mandatory e-pay requirements may apply, see payment issues FAQ 2).

Yes. R&TC Section 19142(b)(1) only allows an exception to the estimated tax penalty when a change during the year is due to a provision of the law that is chaptered during the year. It does not apply to changes due to the application of court decisions.

Audit, protest, and settlement issues.

What if my tax return is currently under FTB audit or in protest for the QSBS issue?

The auditor or hearing officer will resolve this issue as part of the audit or protest process in accordance with FTB Notice 2012-03.

deferrals? - Added February 28, 2013.

Notices of Proposed Assessment (NPAs) will be sent beginning in early April, 2013 and will continue to be issued before the applicable statute(s) of limitations expire.

Yes. A waiver extends the time for FTB to issue an NPA, or for a taxpayer to receive a refund. Taxpayers can contact FTB to request a waiver to extend the expiration of the 2008 statute of limitations. Taxpayers interested in signing a waiver should contact the auditor on their letter (if they received one) or call FTB at 916.845.3030. If interest suspension applies, signing a waiver will extend the interest suspension period – see interest and penalties FAQ 3.

Yes. The normal claim for refund, protest, and appeal time frames and procedures apply.

FTB has established procedures for taxpayers to easily protest the QSBS tax assessments. If you wish to protest the NPA:

Check the appropriate box on the notice. Sign and date in the space provided. Mail or fax a copy to the address or phone number given on the notice.

You do not need to send additional documentation at this time.

Yes. The protest procedures include an option to request that the protest be held pending legislative action. Interest will continue to accrue during the deferral and any subsequent action on the protest, until payment is received.

No. The settlement resolves the issue for the tax year. No further action is required nor will any further action be taken by FTB.

While the FTB typically does not reopen an audit for a tax year after an audit has been completed, we will be issuing notices to taxpayers who claimed this exclusion or deferral for taxable years beginning on or after January 1, 2008, since the Cutler decision represented a "change of law."

LLC issues.

If an LLC now has higher total income because of the elimination of the QSBS benefits, will the LLC fee increase because of the reported sale?

Yes, but only if the adjustment increases the total income of the LLC so as to require a higher LLC fee.

Yes. Under R&TC Section 17942(d)(2), there is no provision in the law, which permits waiver of the LLC fee penalty.

Payment issues.

I am currently making installment payments for tax years prior to 2008. Can I file a claim for refund for those years?

Yes, but the refund may be limited to recovery of payments made within one year of the date of filing the claim.

Yes. In order for your payment to be properly processed, you must check the "tax deposit" box. Please attach a copy of the e-pay receipt to the amended tax return.

There are payment arrangements available. See payment options.

Currently, there is no provision in the law to waive the fees based on a situation like the Cutler decision.

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Qualified Small Business Stock Is An Often Overlooked Tax Windfall.

Editor’s Note: This post was originally published on February 26, 2015. Given recent changes to the tax code, we are updating and re-publishing it.

It’s no secret that small businesses have long been the growth engine of the US economy. With that in mind, Congress has packed the tax code with lots of breaks for those investing in small companies. One of the best, but little known breaks became permanent with the passage of the Protecting Americans from Tax Hikes (PATH) Act on December 18, 2015. I am referring to qualified small business stock (QSBS), a big reason for venture capitalists, angel investors, and entrepreneurs to smile in 2016 and beyond.

Like all things in tax, the IRS definition of qualified small business can get complicated, and it changes depending on the section of the tax code in question. For our purposes, we’ll be focusing on Section 1202 of the Internal Revenue Code (IRC).

To qualify as QSBS under Section 1202:

The stock must be in a domestic C corporation (not an S corporation or LLC, etc.), and it must be a C corporation during substantially all the time you hold the stock. The corporation may not have more than $50 million in assets as of the date the stock was issued and immediately after. Your stock must be acquired at its original issue (not from a secondary market). During substantially all the time you hold the stock, at least 80% of the value of the corporation’s assets must be used in the active conduct of one or more qualified businesses.

To elaborate on the last point, active conduct means a qualified business can’t be an investment vehicle or inactive business. It can’t be, for example:

A service business in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services A banking, insurance, financing, leasing, investing, or similar business A farming business A business involving the production of products for which percentage depletion can be claimed A business of operating a hotel, motel, restaurant, or similar business.

As I mentioned before, this can get really complicated, since each of the points above could be expanded into an in-depth discussion. That being said, in my experience working in Silicon Valley, most early-stage investments in C corporation technology companies meet these requirements.

If you’ve held stock qualifying as QSBS for at least five years when it’s sold (more on this point below), a portion of your gain—or in some cases all of your gain—can be excluded from federal tax . The remaining capital gain is then taxed at a 28% rate (assuming you are in the 15% or 20% bracket for regular long-term capital gains). The maximum gain eligible for exclusion on any one investment is the greater of $10 million or 10 times the taxpayer’s adjusted basis in the stock (which is normally not greater).

It bears mentioning that this post focuses on the federal tax treatment for QSBS. Some states follow the federal tax treatment, while others may have their own set of rules. California, for example, offered preferential treatment for QSBS in prior years, but eliminated the benefit for tax years after 2012. The bottom line: Don’t assume your state provides a benefit for QSBS gain.

In recent years Congress wanted to incentivize more investment in small businesses, so it progressively increased the amount of gain exclusion. Per the table below, there are now several possible treatments for gain exclusion depending on when you purchased your private company stock. Note as well that the gain excluded from capital gains tax is not subject to the 3.8% net investment income tax (NIIT).

The table below summarizes the QSBS rules for regular tax (versus alternative minimum tax) depending on the time frame when the QSBS was first acquired:

As noted in my introduction, the 100% exclusion window was set to expire at the end of 2014, but the passage of the PATH Act on December 18, 2015 made this permanent. That’s not to say the law won’t change in the future with a different Congress or Administration, but it will take another act of Congress to end this tremendous benefit. This should be very welcome news and cause for celebration by all those investing in or starting new qualified small businesses!

To demonstrate the actual tax savings of selling QSBS versus regular stock, let’s look at an example. Say we have a married taxpayer with $450,000 in joint ordinary taxable income. We’ll use $450,000 so we can demonstrate the benefits of QSBS for a taxpayer who is in the 20% long-term gain bracket and also subject to the 3.8% NIIT. Furthermore, let’s assume the taxpayer realizes a long-term capital gain of $100,000 by selling stock on October 1, 2015.

The following scenarios illustrate how the tax due varies depending on the type of stock and its purchase date:

The tax rate is only 23.8% (20% plus the 3.8% NIIT) for the lot purchased in 2013 because none of the stock qualifies as QSBS. As explained above, the higher 31.8% rate (28% plus the 3.8% NIIT) must be applied to QSBS stock.

At this point you may be thinking that QSBS sounds too good to be true, and if you’re subject to the alternative minimum tax (AMT), you would be right. The analysis above oversimplifies the QSBS tax calculation by assuming the taxpayer is not in AMT for the year of sale. For most taxpayers, however, AMT is likely to apply. While Section 1202 excludes a portion of the gain from regular tax, it also adds back 7% of the excluded gain as an AMT preference item. This is true for all purchase periods except the 100% exclusion window, as shown below :

*If the acquisition occurred before January 1, 2000, AMT add back is 42%.

To see the impact of the AMT add back, let’s take a look at our examples again, now assuming the taxpayer is already in AMT before realizing the $100,000 long-term capital gain. Let’s also assume the flat 28% AMT rate fully applies. (Note that lower income levels may also benefit from a partial AMT exemption. I have intentionally used the higher income in this example to clearly show the AMT impact without any exemption.)

Compare the following scenarios for the stock sold below:

As you can see, AMT reduces the potential benefit of selling QSBS for all periods except during the 100% exclusion window. That being said, there’s still a substantial benefit to be had for the 50% or 75% gain exclusions.

Qualifying for QSBS Treatment.

Unfortunately federal and state tax authorities sometimes make it difficult to claim your QSBS benefit. I recommend taking the following steps to support that your sale of QSBS will qualify:

Keep good records for each purchase of stock in your private portfolio, including:

The date purchased The amount paid A copy of the canceled check or wire with your account statement showing the funds leaving your account A copy of the share certificate.

2. Have your stock certified.

If you think you’re making an investment that may eventually qualify for QSBS treatment, ask the company to certify to the following:

That it is a domestic C corporation That it has $50 million or less in assets immediately after your purchase That at least 80% of the company assets are used in the active conduct of a qualifying business.

Note that if you wait several years to ask for this information, the company may not be able to provide it, either due to staff turnover or unclear records.

Keep track of the date when your investment reaches the five-year holding period. You wouldn’t want to sell right before it hit the threshold if you could have waited and paid significantly less or perhaps zero federal tax. This is even more critical now that we are more than five years out from September 28, 2010, the beginning of the 100% exclusion window.

While the five year holding period seems straight forward, there is one common twist worth mentioning. That is the situation when you have QSBS held less than five years and your shares are acquired by a larger company (not a QSBS) where you receive stock in the acquirer instead of cash. You might think that since you sold your shares before the five year hold was met, you wouldn’t qualify for QSBS treatment, but you could be wrong. The shares you receive in the acquirer may actually become QSBS shares in your hands to the extent of the gain at the time of the transaction.

This is best illuminated with an example. Assume you own 1,000,000 shares of QSBS stock in Small Tech, Inc., which represents all of the shares outstanding with a total cost basis of $1,000 that you acquired on February 1, 2013 (during the 100% window). On February 1, 2016, Mega Tech, Inc. acquires all your shares in Small Tech, Inc. in a tax free stock deal worth $5,000,000. You are now holding shares of Mega Tech, Inc. worth $5,000,000 with a cost basis of $1,000, a holding period of three years, and an unrealized gain of $4,999,000. Let’s say, three more years go by (making your QSBS hold more than 5 years) and your Mega Tech, Inc. shares are now worth $6,000,000. At this point, if you were to sell all of the shares, for federal purposes you would have a long-term capital gain of $5,999,000. The first $4,999,000 of said gain would be 100% excluded as QSBS gain while the remaining $1,000,000 would be taxed under the normal rules for long-term gains.

If you’re making a lot of QSBS investments, work with an accountant who understands the rules well.

Other QSBS Opportunities.

QSBS treatment can provide significant tax savings to your private investment portfolio. While this article looked at the benefits available under Section 1202, there are other sections which may provide benefits as well, including Section 1045 for the rollover of gain from one QSBS to another. If you’re going to invest in small businesses—including technology start-ups—it’s well worth your time to engage a qualified tax accountant to help you learn how to use QSBS to your portfolio’s advantage.

Wealthfront, Inc. is an SEC registered Investment Advisor. This article is not intended as tax advice, and Wealthfront does not represent in any manner that the outcomes described herein will result in any particular tax consequence. Prospective investors should confer with their personal tax advisors regarding the tax consequences based on their particular circumstances. Wealthfront assumes no responsibility for the tax consequences to any investor of any transaction. Financial advisory services are only provided to investors who become Wealthfront clients. Past performance is no guarantee of future results.

The material appearing in this communication is for informational purposes only and should not be construed as legal, accounting, or tax advice or opinion provided by Moss Adams LLP. This information is not intended to create, and receipt does not constitute, a legal relationship, including, but not limited to, an accountant-client relationship. Although these materials have been prepared by professionals, the user should not substitute these materials for professional services, and should seek advice from an independent advisor before acting on any information presented. Moss Adams LLP assumes no obligation to provide notifications of changes in tax laws or other factors that could affect the information provided.

About the author.

Toby Johnston CPA, CFP is a partner with the Moss Adams LLP Wealth Services Practice.

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100 Percent Tax Exemption for Gain on Certain Qualified Small Business Stock Expiring at Year End.

December 12, 2013.

In January 2013, Congress enacted legislation that could provide certain investors who acquire qualified small business stock (“QSBS”) before the end of 2013 with a significant tax benefit. In effect, the gains realized from the sale or exchange of QSBS acquired by eligible investors after September 27, 2010 and on or before December 31, 2013 and held for more than five years may qualify for a 100 percent exclusion from federal income tax. Under this temporary 100 percent exclusion, excluded gains also are exempt from the alternative minimum tax. As a result, the effective federal income tax rate on capital gains that qualify for this exclusion generally will be zero. The maximum amount of gain eligible for the exclusion with respect to the stock of a single issuer is the greater of $10 million or 10 times the investor’s basis in the stock of the issuing corporation.

Unless Congress acts, QSBS acquired after December 31, 2013 will revert to the original QSBS rules, which generally provide for a 50 percent exclusion of gain from qualifying sales of QSBS, subject to the alternative minimum tax.

Eligible Investors.

Only non-corporate investors, including individuals, estates and trusts, qualify for the benefits of the QSBS gain exclusion rules. A non-corporate investor that owns an interest in a flow-through entity (such as an LLC, partnership or S corporation) also may be eligible for the exclusion with respect to their share of the gain from the sale of QSBS held by the flow-through entity, provided that certain special rules are satisfied.

Qualified Small Business Stock.

Stock is QSBS only if the investor acquired the stock at original issue from a corporation that is a “qualified small business” (described below) in exchange for money or property (other than stock) or as compensation for services to the corporation (other than as an underwriter of the stock).

Acquired at Original Issue.

The tax benefits of the QSBS exclusion are available to investors (including service providers and founders) that acquire stock (but not options, warrants, phantom stock rights or debt) from the issuing corporation. As previously described, the stock must be acquired from the corporation in exchange for money or property (other than stock) or as compensation for services (other than as an underwriter). For this purpose:

Conversion of debt; exercise of warrants or options . The conversion of debt into stock and the exercise of investor warrants or employee stock options are treated as acquisitions of stock at original issue. Conversion of an LLC or partnership to C corporation . If an LLC or partnership is converted into a C corporation, C corporation stock issued in the conversion to members or partners of the LLC or partnership is treated as the acquisition of stock at original issue. However, the temporary 100 percent exclusion would only apply to any appreciation in value of the C corporation stock that occurs after the conversion transaction.

Qualified Small Business Requirement.

For stock to qualify as QSBS, the issuer of the stock generally must satisfy the following requirements:

The issuer must be an eligible domestic C corporation. DISCs, RICs, REITs, REMICs, FASITs, cooperatives and certain other special types of corporations are not eligible corporations. The aggregate gross assets of the issuer must not have exceeded $50 million (as determined under special rules) at any time from inception up to the time immediately after the issuance of stock to the applicable investor. The corporation must submit any reports that the IRS requires. Currently, the IRS has not created any reporting requirements for QSBS issuers. The issuer must use at least 80 percent (by value) of its assets in the active conduct of one or more qualified trades or businesses during substantially all of the applicable investor’s holding period. It should be noted that: A number of types of businesses are expressly excluded from being “qualified trades or businesses.” For example, any trade or business involving the performance of services in the fields of health, law, engineering, consulting, financial services and many other types of service businesses will not qualify. In addition, hotel, restaurant, oil, gas, banking, investment, farming and certain other types of businesses will not qualify. Research and start-up activities in connection with a future qualified trade or business generally may be treated as the active conduct of the qualified trade or business, regardless of whether these activities have generated any gross income. For purposes of the 80 percent test, in addition to assets clearly used in the active conduct of a qualified business, the following assets also may be counted as used in the active conduct of the business: (1) assets held for working capital needs; and (2) assets held for investment that are reasonably expected to be used within two years to finance research and experimentation in a qualified trade or business or to finance increases in the corporation’s working capital needs. If a corporation has been in existence for at least two years, however, no more than 50 percent of the assets of the corporation will qualify as used in an active trade or business by reason of the rules described in (1) and (2). There are limitations on the amount of portfolio stock and real estate that a corporation may hold and still be considered engaged in the active conduct of a qualified trade or business. An otherwise eligible corporation that is licensed to operate as a “specialized small business investment company” (or SSBIC) under section 301(d) of the Small Business Investment Act of 1958 (as in effect on May 13, 1993) is deemed to satisfy the active business requirements.

Certain redemptions by the issuing corporation of its stock within two years (or one year, in some cases) before or after the issuance of stock may disqualify the issued stock from QSBS status.

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Nicola Lemay.

Earl W. Mellott.

Christopher R. K. Cawley.

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Qualified Small Business Stock (QSBS) Year-End Considerations.

UPDATE: The fiscal cliff bill renewed the 100% exclusion (subject to the generous cap) under Section 1202 for investments made from September 27, 2010 through the end of calendar year 2013. See here: startuplawblog/2013/01/01/fiscal-cliff-bill-would-renew-100-exlusion-for-qsb-stock-investments/

Noncorporate investors who sold or plan to sell QSBS in 2011 and are expecting a large tax windfall under Section 1202 of the I. R.C. (“Section 1202”) will likely be disappointed. In general, the tax break under Section 1202 for gain realized by a noncorporate investor on the sale or exchange of QSBS in 2011, which is held by such investor as a capital asset and for a period of over 5 years, is about 1%. So why are people making such a big deal about Section 1202 as this year comes to a close?

Noncorporate investors who acquire QSBS after September 27, 2010, and before January 1, 2012, hold the stock for over 5 years, and then sell the stock at a gain will generally be able to exclude 100% of such gain (up to a minimum of $10 million) for both regular tax and AMT purposes. That’s right, potentially a 0% federal income tax! Of course, this assumes all of the other tests in the fine print of the rules are satisfied.

If you are looking for ways to take advantage of Section 1202 before year-end, here are some considerations:

If you have a business that is held as a sole proprietorship, a single-member LLC or a partnership, then you should consider incorporating the business by the end of the year. For the 100% exclusion under Section 1202 to apply, the business has to be held as a domestic “C” corporation when the QSBS is issued to the investor or founder and during substantially all of their holding period of the QSBS. If the business has always had less than $50 million in gross assets, the owners who receive original issue stock upon incorporation of the business can generally qualify for the 100% exclusion under Section 1202 (assuming all other tests are met). However, incorporating a business can have unexpected immediate and long-term tax and legal consequences, so be sure to get good advice before making the change. If you are considering issuing stock options to key employees, board members, or service providers before the end of the year, think about using restricted stock instead. A stock option itself likely cannot qualify as QSBS, but stock received by exercising options likely can become QSBS on the date the option is exercised (i. e., when the stock is actually received), assuming the applicable requirements are met. On the other hand, restricted stock (with respect to which a valid Section 83(b) election is made at the time of issuance) likely can become QSBS when received, assuming the applicable requirements are met. Make sure that investors actually receive stock before the end of 2011. Having the investor cut a check to the company in 2011 which will be held by the company until the round closes and the stock is issued to investors (in 2012) will not likely qualify the stock for the 100% exclusion under Section 1202. In other words, the classic “rolling close” on an investment round could be a problem for investors, if the close doesn’t occur before January 1, 2012. If you are a CEO of a start-up, make sure that the company meets the detailed requirements under Section 1202 before you make any representations to potential investors. Because the 100% exclusion under Section 1202 is so beneficial to investors, this could become very contentious in 5 years when an investor is seeking the benefit in the midst of a delicate exit event. Few things are worse than having a disgruntled investor around when trying to close a deal. These requirements are much more complex than many executives (and even their advisors) often realize. If you do invest in QSBS in 2011, track your purchase date (and cost basis) carefully. You don’t want to find out after the fact that you sold your stock too early to enjoy the 100% exclusion under Section 1202. Want to make an investment through a pass-through entity? A partnership or “S” corporation can hold QSBS. As a partner/shareholder of such pass-through entity you can generally still enjoy the 100% exclusion under Section 1202 with respect to gain realized by the entity on the sale of QSBS allocated to you provided the applicable requirements are met. However, a requirement for the 100% exclusion under Section 1202 is that you must be a partner/shareholder on the date on which the pass-through entity acquired the QSBS and at all times thereafter until the entity sells the QSBS. Do you hold a convertible note issued by a qualified small business? You should consider converting the note before the end of 2011. Although a convertible note itself cannot qualify as QSBS, stock received by converting the note likely can become QSBS on the date the stock is issued, assuming the applicable requirements are met. Of course, to obtain the benefit of the 100% exclusion under Section 1202, the conversion would need to be completed (i. e., you receive your stock) before January 1, 2012. If you convert after the end of the year, the stock will be issued after the cut-off date, and it will not qualify for the 100% exclusion under Section 1202.

Dan Wright is a CPA and a tax consultant with Clark Nuber P. S. in Bellevue where his practice focuses on serving emerging businesses. His areas of expertise include federal and state taxation of technology companies, executive compensation arrangements, choice of business entity issues, and business buy/sell/combination transactions. Dan holds a Master’s in Taxation degree from Brigham Young University. He enjoys hiking, biking and playing blues guitar.

*Please note that the views and opinions expressed in this guest blog post are not necessarily that of Davis Wright Tremaine and Joe Wallin.

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