Key takeaways

Investors (especially founders, entrepreneurs, employees, and VC and PE investors) may now be able to exclude from US federal income taxation between USD 15 million and USD 750 million of capital gains relating to each issuing corporation's QSBS.

If structured properly, founders, entrepreneurs and employees may be able to take advantage of up to USD 750 million of capital gains exclusion without investing any money in a business by:

• Starting a qualified trade or business as a sole proprietorship or in an entity that is either disregarded as separate from its owner or taxed as a partnership, 
• Building up the value of that business to USD 75 million (e.g., through sweat equity), and
• Converting the entity holding the business to a C corporation, electing to have that entity be taxed a C Corporation, or contributing the assets of the business or the equity interests of the entity holding the business to a C Corporation (each of which starts the holding period for QSBS purposes).

Background

In the wake of the Great Financial Crisis, President Obama signed into law certain changes to Section 1202 that were designed to incentivize investments in startups and certain other small businesess.  These changes increased from 75% to 100% the percentage of capital gains from QSBS that would be excluded from the calculation of such taxpayer's gross income, made such increase permanent, and made such exclusions no longer subject to the alternative minimum tax (AMT). 

Prior to the Act, individuals and certain non-corporate taxpayers could exclude a cumulative amount ("Exclusion Amount") of capital gains earned from investing in QSBS of a particular issuing corporation equal to the greater of (i) ten times (10x) their investment in QSBS issued or granted by each particular corporation or (ii) USD 10 million with respect to a partciular issuing corporation's QSBS. These numbers were halved for married taxpayers filing separately.

For those well-advised founders, entrepeneurs, employees and investors, these changes allowed for the earning of between USD 10 million and USD 500 million in capital gains with respect to each corporation's QSBS without being liable for US federal income tax.

Note: Many states (including California and New York) tax capital gains with respect to QSBS regardless of the US federal income tax exclusion.

Before the Act, in order for stock to qualify as QSBS, all the following requirements needed to be met:

• The corporation issuing the stock had to be a C corporation (or an entity taxed as a C corporation).
• The taxpayer needed to:
  • Acquire his, her or its stock at original issuance as a result either of (a) a purchase of the stock from the issuing corporation for cash or a contribution of certain non-cash property to the issuing corporation in exchange for the stock (i.e., the taxpayer could not purchase the stock on a secondary market or from another investor) or (b) the granting of stock as compensation for services or
  • Acquire his, her or its stock via gift, inheritance or partnership distribution, in each case, generally from a person or entity that acquired it in a manner described in first clause.
• If the taxpayer acquired his, her or its stock at original issuance (as described above), the issuing corporation's "aggregate gross assets" (i.e., the sum of the corporation's cash plus the tax basis of its non-cash assets) at all times before and immediately after the issuance could not exceed USD 50 million (collectively, the "Gross Asset Test"); 
• Subject to certain exceptions, during the entire period which the taxpayer (and certain transferors) held the stock, the issuing corporation must have used at least 80% of its assets in the conduct of one or more "qualified trades or businesses" (as defined for QSBS purposes); and
• The issuing corporation could not have engaged in certain redemption transactions.

Basic rules

Section 1202 provides specific rules for determining a taxpayer's tax basis in QSBS.  If a taxpayer contributes non-cash assets to the corporation in exchange for QSBS, the taxpayer's investment in the QSBS (or its tax basis in the QSBS), which is used to calculate the taxpayer's Exclusion Amount and the amount of capital gains realized for QSBS purposes, will equal the fair market value of the contribution.

When calculating a taxpayer's basis for purposes of determining how much capital gains the taxpayer realizes in connection with a sale of the stock for regular (non-QSBS) income tax purposes, the taxpayer's basis in the stock will generally equal the tax basis of the assets the taxpayer contributed to the issuing corporation in exchange for that stock (assuming the contribution was tax-free). Therefore, if there was built-in gain in the assets contributed to a corporation in exchange for the QSBS, the contributing taxpayer will still need to recognize (and pay tax on) that built-in gain upon sale of the QSBS stock.

Example: If a taxpayer forms a new C corporation and contributes assets with a fair market value of USD 70 million but that have USD 0 tax basis, the taxpayer will be eligible to exclude up to USD 700 million in capital gains (if the requirements of section 1202 are met), but, in general, the first USD 70 million of capital gains will still be subject to tax. In other words, in order to get the maximum benefit with respect to such QSBS, the taxpayer needs to sell his, her or its stock for at least USD 770 million.

Likewise, for purposes of determining whether a corporation meets the Gross Asset Test, the tax basis of non-cash assets contributed to the corporation also equals the fair market value of such assets. It is unclear how liabilities, depreciation and amortization, with respect to contributed assets, affect the Gross Asset Test calculation. IRS guidance is needed on these points.

Enhancement and expansion of QSBS benefits

The Act made significant changes to the amount of QSBS benefits available, what stock qualified as QSBS and how long a taxpayer needed to hold that stock before it obtained benefits under section 1202.

Increased minimum exclusion amount: For QSBS issued by a corporation after the Effective Date, the Exclusion Amount for each applicable taxpayer will be at least USD 15 million. As before, this number is halved for married taxpayers filing jointly. In addition, the USD 15 million minimum exclusion will be inflation adjusted beginning in tax years after 2026.

Prior to the Act, the minimum Exclusion Amount was a static USD 10 million.

Partial exclusion if QSBS held for at least three years: If a taxpayer holds QSBS issued after the Effective Date for at least:

• Three years, then 50% of the capital gains realized (up to the Exclusion Amount) will be excluded from the applicable taxpayer's gross income; 
• Four years, then 75% of the capital gains realized (up to the Exclusion Amount) will be excluded from the applicable taxpayer's gross income; and
• Five years, then 100% of capital gains realized (up to the Exclusion Amount) will be excluded from the applicable taxpayer's gross income.

QSBS benefits are no longer "all or nothing". Prior to the Act, if a taxpayer sold QSBS one day before the end of the five-year holding period, the taxpayer lost 100% of the QSBS benefit.  As a result of the Act's changes, a taxpayer will be able to obtain between 50% and 75% of the QSBS benefits if they acquire QSBS after the Effective Date and hold it for at least three but less than five years.

Because capital gains that qualify for some (but not a 100% exclusion) under Section 1202 are subject to a US federal tax rate of 28% + 3.8% (as compared a tax rate of 20% + 3.8% for non-QSBS capital gains), the effective tax rate applicable to capital gains relating to QSBS held for at least three years but less than four years will be 15.9%. Similarly, the effective tax rate on the capital gains will be 7.95% for QSBS that is held for at least four years but less than five years.

Relaxation of the Gross Asset Test: For stock issued after the Effective Date, in order to qualify as QSBS, the corporation's aggregate gross assets at all times prior to and immediately after the issuance cannot exceed USD 75 million. This means that if a corporation's aggregate gross assets exceeded USD 50 million before the Effective Date, but never exceeded USD 75 million, the corporation still may be able to issue QSBS. In addition, the USD 75 million limit will be adjusted for inflation beginning in tax years after 2026.

Prior to the Act, the Gross Asset Test was a static USD 50 million.