What Happened
President Biden has proposed to increase long-term capital gains tax rates to ordinary income rates for taxpayers earning more than $1 million per year. Thus, under the Biden tax proposal a shareholder selling their business stock for more than $1 million would pay a maximum combined federal and California capital gains tax rate of 56.7%.
Qualified Small Business Stock – A Lucrative Tax
One tax provision that neither the Biden administration nor Congress has yet proposed to repeal is the Qualified Small Business Stock (“QSBS”) provisions under Section 1202 of the Internal Revenue Code. Stock qualifying for QSBS treatment can qualify for excluding gain from federal income taxes (Please see below for details).
This is something newly formed businesses should consider for choice of entity. Existing partnerships may also consider conversion to C Corp to avail themselves of QSBS favorable treatment on post conversion gain.
We’re Here to Help
California does not have a similar QSBS tax exclusion. There may be tax planning ideas to permanently move out of California or establish out of state trusts to own the business stock.
Should you have questions on the above, please give us a call or send an email. We will continue to deliver updates on Tax Alerts and other developments.
Additional details
1. Federal Income Tax Benefits of Qualified Small Business Stock
For domestic C corporation shares that were acquired by the taxpayer on or after September 27, 2010, the taxpayer could exclude up to 100% of the gain from the stock sale (including the 3.8% net investment income tax), but subject to the limits discussed in paragraph 4, below. This exclusion from gain recognition percentage falls to between 50% to 75% for stock issued on or before September 27, 2010.
2. Qualified Small Business
Qualified Small Business specifically excludes businesses such as financial companies, performing arts, athletics, energy production, hospitality, hotels and farming. Service industries such as accounting, engineering, brokerage services, healthcare, banking and insurance are also specifically excluded.
3. The Following Requirements Must Also be Satisfied:
- The stock must be acquired at the stock’s original issuance after August 9, 1993, in exchange for money or other property (not including stock) or as compensation for services provided to the issuing corporation;
- The corporation must conduct an “active business” for substantially all of the shareholder’s holding period;
- The corporation must be a C corporation;
- The shares must have been held by that shareholder for at least five (5) years;
- The shares must be issued to a noncorporate shareholder;
- The tax basis of the gross assets of the corporation at all times from August 10, 1993 until immediately after the issuance of the taxpayer’s stock must be less than $50 million;
- Certain redemptions can retroactively eliminate QSBS treatment
4. Gain Exclusion Limitations
A significant benefit of QSBS held more than five (5) years is to exclude the greater of:
- $10 million of capital gains reduced by the gain excluded by the taxpayer under §1202 for prior tax years of that same issuer; or
- Ten (10) times the adjusted basis of the QSBS of that issuer that is disposed of by the taxpayer during the tax year.
This limitation is per each shareholder and is $10 million for two spouses filing a joint return.
5. Ability to Rollover the Gain on the Sale of Qualified Small Business Stock
Electing shareholders can sell their QSBS in a taxable transaction and purchase new QSBS within sixty (60) days to avoid recognizing gain as long as the QSBS is held for at least six (6) months and that the sales proceeds do not exceed the amount invested in the new QSBS shares.
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