FAQ: Who is eligible for the small business stock exclusion?

Included among the many important individual and business incentives extended and enhanced by the massive tax bill passed in late December is a 100-percent exclusion of gain from the sale of qualified small business stock. Under the Tax Relief, Unemployment Reauthorization and Job Creation Act of 2010 (2010 Tax Relief Act) individuals and other noncorporate taxpayers should not overlook the benefit of investing in qualified small business stock considering the ability for qualifying taxpayers to exclude 100-percent of gain from the sale or exchange of the stock. There are certain limitations, however, regarding who qualifies for the tax break, holding periods, and what qualifies as qualified small business stock.

What is qualified small business stock?

The 100-percent exclusion from gain for investing in qualified small business stock is intended to encourage investment in small businesses and specialized small business investment companies. To qualify as small business stock for purposes of the 100-percent exclusion:

— The stock must be issued by a C corporation that invests 80-percent of its assets in the active conduct of a trade or business and that has assets of $50 million or less when the stock is issued;
— Qualified stock must be must be held for more than five years (rollovers into other qualified stock are allowed);
— The amount taken into account under the exclusion is limited to the greater of $10 million or ten times the taxpayer’s basis in the stock;
— Any taxpayer, other than a C corporation, can take advantage of the exclusion.

Tax benefits

The 2010 Small Business Jobs Act enhanced the exclusion of gain from qualified small business stock to non-corporate taxpayers. For stock acquired after September 27, 2010 and before January 1, 2011, and held for at least five years, the 2010 Small Business Jobs Act provided an exclusion of 100 percent.

The 2010 Tax Relief Act extends the 100 percent exclusion for one more year, for stock acquired before January 1, 2012. As a result of the extension of the 100-percent exclusion, none of the gain on qualifying sales or exchanges of qualified small business stock is subject federal income tax or AMT will be imposed on gain from the sale or exchange of qualified small business stock that is acquired after September 27, 2010 and before January 1, 2012, and that is held for more than five years. In addition, the excluded gain is not treated as a tax preference item for AMT purposes, so none of the gain will be subject to AMT.

The holding period requirement

Because of the various changes to the percentage of the exclusion, a taxpayer must be aware not only of meeting the five year holding requirement, but also of the date the qualified small business stock was acquired.

For example, if you acquired qualified small business stock after February 17, 2009 and before September 28, 2010, then only 75 percent of the gain will be subject to tax if the stock is sold or exchanged more than five years later. If you acquired qualified small business stock on February 17, 2009, then only 50 percent of the gain will be subject to tax if the stock is sold or exchanged after February 17, 2014. If you acquired the stock after September 27, 2010 and before January 1, 2012, then no tax will be imposed on the gain if the stock is sold or exchanged more than five years later.

Eligibility

To be eligible for the exclusion, the small business stock must be acquired by the individual at its original issue (directly or through an underwriter), for money, property other than stock, or as compensation for services provided to the corporation. Stock acquired through the conversion of stock (such as preferred stock) that was qualified stock in the taxpayer’s hands is also qualified stock in the taxpayer’s hands.

However, small business stock does not include stock that has been the subject of certain redemptions that are more than de minimis. If you acquire or acquired qualified stock by gift or inheritance, you are treated as having acquired that stock in the same manner as the transferor and will need to add the transferor’s holding period to your own.

A partnership may distribute qualified stock to its partners so long as the partner held the partnership interest when the stock was acquired, and only to the extent that partner’s share in the partnership has not increased since the stock was acquired.