The 100% Qualified Small Business Stock Exclusion
In a little noted but hugely significant provision of the American Taxpayer Relief Act of 2012 (“ATRA"), Congress has extended the 100% exclusion from tax for gains from the sale of Qualified Small Business Stock (QSBS) held for more than 5 years. Although it seems to have come as an afterthought, the QSBS exclusion may be one of the bigger job creators in the bill. Under the extension, up to $10 million of gain from QSBS purchased in 2010 – 2013 is exempt from tax, including alternative minimum tax (“AMT").
As described in a previous blog post, QSBS includes originally issued stock in a C corporation that conducts an active trade or business and has less than $50 million of gross assets at the time of issuance. See Valuable QSBS Opportunity for Investors and LLC’s to End on December 31, 2011.
The new provision could have a big tax effect – taxpayers who are not being taxed at a federal rate of as high as 39% (with state rates, one of the highest in the world) have a path for avoiding tax entirely on the gains from startup company investments. The bad news (for Californians) is that this change in the law comes at a time when California’s Franchise Tax Board (FTB) has determined that there simply is no QSBS exclusion for California income tax purposes (not even a rollover). While the long term viability of the California rule is doubtful, the federal tax law change makes startup investing that much more attractive.
As a planning matter, the QSBS exclusion complicates the choice of entity decision. Generally, limited liability companies (LLCs) and S corporations are favored forms of entity because their earnings are subject to only one level of tax (once at the owner level) whereas a C corporation’s earnings are subject to two levels (once at the corporate level and again at the shareholder level when the earnings are distributed). The distinction is somewhat illusory, however, because even a QSB must pay corporate taxes at the corporate level on its corporate income. Nevertheless, if the exit is a stock sale before the company hits profitability, the new rule makes the tax stakes a little less clear (i.e. trading one level of tax at the corporate level (QSB) for one level of tax at the owner level (LLC or S corp)). Unfortunately, there will be no one size fits all solution, and tax will be one factor in the equation.