“Permanent” Changes in Federal Tax Laws: Can investors eliminate or reduce capital gains tax?

If you are an investor in earlier stage companies, how would you like to legally (!) avoid paying federal capital gains tax and reduce or eliminate your state’s capital gains tax on gains from these investments?

A new law now makes permanent the 100% exclusion for gains on qualified small business stock (“QSB Stock”) under Section 1202 of the Internal Revenue Code (the “Code”). This 100% exclusion applies for both regular federal income tax and alternative minimum tax (“AMT”) purposes, subject to certain limitations as described below.
Code Section 1202 provides that a non-corporate investor may exclude from federal taxable income 100% of any gain realized from the sale of QSB Stock purchased after September 27, 2010 and held for more than five years.  The amount of the exclusion for shares purchased prior to September 2010 will depend upon the year in which the shares were purchased, but the exclusion amount ranges between 50-75% for shares purchased between 1994 and 2010.

To qualify as QSB Stock, the following requirements generally must be satisfied:

  • The investor must purchase the stock directly from the company in exchange for cash, property (other than stock), or as compensation for services (other than as an underwriter of the stock).
  • The stock must be issued by a domestic C corporation (and not an LLC or S corporation) that does not have aggregate gross assets in excess of $50 million any time prior to or immediately after the issuance of the stock.
  • The issuer must satisfy the “active business” requirement during substantially all of the investor’s holding period. The active business requirement requires that at least 80% of the corporation assets are used in the active conduct of one or more “qualified trades or businesses.” Certain services based businesses, such as professional services, financial and brokerage services, banking, and insurance businesses, among others, do not qualify as qualified trades or businesses.

The amount of gain an investor may exclude under Section 1202 cannot exceed the greater of: (i) $10 million (less any gain attributable to the issuer’s stock already excluded by the investor in prior tax years); and (ii) 10 times the aggregate adjusted basis of all of the issuer’s QSB Stock disposed of by the investor during the current tax year.

Losses on unsuccessful QSBS investments are also eligible for certain favorable tax treatment. While losses on investments are capital losses, they typically may only offset capital gains. Since capital gains are taxed at rates lower than ordinary income, it is almost always more beneficial to have losses that are usable to offset ordinary income. The Code provides an exception for losses on QSB Stock investments, allowing taxpayers to treat up to $50,000 in annual losses from QSB Stock investments as ordinary losses (which will offset ordinary income). Thus, in the event of an unsuccessful QSB Stock investment, the loss results in a more valuable tax asset than those generated by non-QSB Stock investments.

Whether or not gains from the sale of QSBS investments will be taxed on a state level depends entirely upon the state. Under Massachusetts income tax laws, gains from the sale or exchange of capital assets (except collectibles) held for more than one year are generally taxed at 5.1%, except that long-term gains from the sale of qualified small business stock are taxed at 3%. Certain provisions for exemption under the Massachusetts income tax laws differ from the federal tax law, so if you are a Massachusetts investor, you should check with your tax advisor.

The permanent nature of the new 100% exclusion, and the 2010 amendments to the Code which eliminated QSB Stock gains from AMT, make the use of a Section 1202 exemption of particular importance to individual investors. Due to the complex requirements under Section 1202 of the Code, investors and issuers should consult with their tax advisors regarding their specific circumstances prior to relying on Section 1202.


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