Tax-free business stock

Shares in a ‘qualified small business’ can be eligible for a significant exclusion

An often overlooked provision in the tax code can eliminate up to 100 percent of the tax due on the sale of certain small business stock.

Shareholders who sell stock that meets all of the requirements of Section 1202 of the code are eligible to exclude between 50 and 100 percent of all or a portion of the gain from the sale. This could represent a significant tax savings for qualifying business founders and investors by allowing them to avoid tax on up to $10 million of the gain on a sale of their stock.

Some basics: To be eligible for the exclusion, the stock has to be issued by a “qualified small business” and the shareholder must have held the stock for more than five years prior to sale and been purchased at its original issue for either cash or other property or received it as compensation for services provided to such business.

The exclusion is not available for qualified small business stock owned by a corporation.

A “qualified small business” is a domestic “C” corporation that issued its stock after Aug. 10, 1993, provided that its total aggregate gross assets did not exceed $50 million at any time from Aug. 10, 1993, to the date of the stock issuance and immediately after the stock issuance. There is no asset test at the time the stock is sold, so a company can still be a “qualified small business” even if at the time of the stock sale the company’s worth exceeds $50 million. However, there is a limitation on the amount of gain that can avoid tax, as explained more fully below. 

Interests in sole proprietorships, “S” corporation stock and interests in partnerships and limited liability companies that are taxed as partnerships for federal income tax purposes are not eligible for the exclusion.

Only stock in an “active” business that is engaged in a “qualified trade or business” is eligible for the exclusion. A business is considered “active” if during substantially all of the time period of the shareholder’s ownership of the stock, the business is a “C” corporation and such business devotes at least 80 percent (by value) of its assets in the active conduct of one or more qualified trades or businesses.

A “qualified trade or business” is any trade or business other than: one involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees; any banking, insurance, financing, leasing, investing or similar business; any farming business (including the business of raising or harvesting trees); certain businesses eligible for depletion deductions; and any business of operating a hotel, motel, restaurant, or similar business.”

Certain types of corporations such as regulated investment companies, real estate investment trusts, and real estate mortgage investment conduits are also excluded from the definition of a qualified small business. 

A “qualified small business” is also limited in the amount of real estate it may own and the amount of stock in non-affiliated companies it can own in order to meet the active business requirement.

An investment company generally only qualifies as a small business under this exclusion if it is a specialized small business investment company under section 301(d) of the Small Business Investment Act of 1958. 

If you have owned qualified small business stock for more than five years, the percent of gain excluded from income ranges from 50 percent to 100 percent, depending on when the eligible stock was acquired. Stock acquired on or before Feb. 17, 2009, is eligible for a 50 percent exclusion. Stock acquired after Feb. 17, 2009, and before Sept. 28, 2010, is eligible for a 75 percent exclusion. Stock acquired after Sept. 27, 2010, is eligible for a 100 percent exclusion.

In addition, a shareholder is limited to the greater of $10 million of gain or 10 times the shareholder’s basis in the qualified small business stock. This limitation is applied on an entity-by-entity basis; accordingly, a shareholder who owns qualified small business stock in more than one company may be eligible to exclude up to $10 million from income for each company sold. The $10 million limitation is decreased to $5 million for taxpayers filing as married filing separately. 

Attorneys Peter Beach and Russell Stein work in the Tax Department of the Manchester-based law firm of Sheehan Phinney Bass +Green.