One under-publicized tax planning opportunity contained in the 2010 Tax Relief Act that was passed at the end of December 2010 (the “Act”) is a provision extending the 100% capital gains exclusion for investments in “qualified small business stock” (“QSBS”). The 100% tax exclusion is an attempt to encourage investment in startups, new ventures, and small businesses. Although originally set to expire at the end of 2010, this capital gains exclusion now runs for any purchase or investment in QSBS on or before December 31, 2011.
Any new startup deciding on the choice of entity should consider the valuable benefits of this capital gains exclusion. Under the Act, a taxpayer will not have to pay taxes (federal only) from any capital gains in the sale of any QSBS that is held for more than five years, as long as that stock was purchased after the enactment date and before January 1, 2012
In order for the QSBS to qualify for the capital gains tax exclusion, the QSBS must satisfy the following requirements:
(1) It must be stock (warrants do not themselves qualify but exercise of a warrant for stock is an acquisition) acquired at its original issuance for money, property or services provided to the issuing corporation.
(2) The corporation issuing the stock must be a qualified small business, which is defined as a C Corporation, with aggregate gross assets of less than $50 million at any time before the issuance of the QSBS to the applicable taxpayer or related person, as well as immediately after the issuance of the stock.
(3) The corporation must satisfy the active business requirement. It cannot be a holding company.
(4) The taxpayer must hold the stock for more than five years.
The amount of capital gain exclusion is capped to the greater of $10 million or ten times the taxpayer’s investment in the QSBS. A taxpayer should consider taking advantage of this temporary capital gains exclusion in any of the following scenarios:
(1) Forming and issuing stock in a “C” corporation startup before the end of 2011.
(2) Exercising an employee stock option or investor warrant.
(3) Investing in additional stock of an existing startup that qualifies as a QSB.
(4) Converting an existing LLC or partnership into a QSB corporation to attract investors that wish to take advantage of this temporary tax exclusion.
(5) Converting convertible debt to stock.