Fiscal Cliff Deal Eliminates Taxes on Certain Sales of "Qualified Small Business Stock"

January 23, 2013
Legal Updates

Certain capital gains on "qualified small business stock" are once again exempt from federal taxation under Section 1202 of the tax code. This exemption previously expired on December 31, 2011, but the 2012 American Taxpayer Relief Act (the "2012 Act"), signed into law in early January to avert the so-called "fiscal cliff," included a provision extending this exemption to "qualified small business stock" acquired at any time during 2012 or 2013 .

Under Section 1202, "qualified small business stock" is stock issued by a C corporation that meets certain requirements. The corporation's total gross assets may not exceed $50 million before issuing the stock, and the corporation must be engaged in the active conduct of a business (excluding certain activities, such as banking, investing, farming, mining, and operating restaurants, hotels, or professional services firms).  Various other restrictions apply, including strict limitations on stock redemptions.

To obtain the exclusion for capital gains, the qualified small business stock must be held for at least five years.   The amount that can be excluded on a particular company's stock is limited to the greater of $10 million or 10 times the aggregated adjusted basis of the qualified small business stock.  If stock is exchanged in a tax-free merger or other reorganization, the holding period of the original shares and the new shares is tacked together for purposes of satisfying the five year requirement and when the shares are ultimately sold, all of the gain may qualify for Section 1202 treatment.

The Section 1202 gain exclusion can be especially attractive to higher income taxpayers because it is not a tax preference for purposes of the alternative minimum tax.  Moreover, the excluded gain will not be subject to the new 3.8% Medicare surtax on capital gains applicable to high-income taxpayers.

The 2012 Act modified the method for determining when stock is "acquired" for purposes of Section 1202.  Under the new rules, if the holding period of newly issued stock is tacked onto a taxpayer's holding period for other securities that were exchanged for the stock, then the "acquisition date" of the stock will be the beginning of the earlier holding period. Therefore, if an LLC interest is converted into stock, the holding period of the LLC interest counts towards the five year holding period.  However, if this tacked holding period creates a holding period commencing prior to September 28, 2010, the zero percent treatment will not be available.  

We expect that the changes to Section 1202 will increase interest in qualified small businesses in 2013, and may lead investors and business owners to consider structuring transactions to take advantage of this potential exclusion.  Small business owners seeking additional capital may consider organizing new ventures as C corporations, or converting existing LLCs or S corporations into C corporations prior to seeking new investment.  Business owners should be aware, however, that the opportunities presented by Section 1202 all require thoughtful planning.