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Capital gain rules benefit family businesses and investors
Once known as “Furniture City” and now “Beer City USA,” Grand Rapids has long been a home to innovation and entrepreneurs. Want to create a supermarket and see it spread to more than 190 stores in five states, or turn cleaning products into a global enterprise? Grand Rapids might be just the place for your family business startup to become the next big thing, or for your existing family business to invest in a startup and share in its success as it grows.
Unfortunately, success usually leads to taxes. There are tax-saving laws to encourage startup investment, but the timing is important: If you acquire qualified small business stock, or QSBS, before the end of the year, then hold the stock for at least five years, you may be able to exclude 100 percent of the gain realized on the future sale of that stock. The same stock acquired in 2014 or later is eligible for only 50 percent gain exclusion.
This article will discuss what qualifies as QSBS, the rules and limitations of excluding capital gain, and how family business entrepreneurs and investors can use these rules to their advantage.
Stock must meet several criteria to be QSBS eligible for the gain exclusion. First, the stock must be issued by a domestic C corporation after Aug. 10, 1993, and that corporation’s total gross assets must be $50 million or fewer at all times before the stock is issued and immediately thereafter.
Despite this initial limitation, however, there is no ceiling on the size to which the company can later grow. So, if a family member wants to start a new corporation, it is considered a “small business” for purposes of the gain exclusion rules as long as its assets are $50 million or fewer before (and immediately after) its stock is issued. Ambitious entrepreneurs won’t be satisfied with a “small” $50 million in assets for long, but once the stock is issued, the corporation is free to accumulate enough billions to at least not be embarrassing during dinner party discussion. Investors must acquire the stock at its original issue, however, either directly or through an underwriter, and in exchange for money, other property, or as pay for services rendered to the corporation.
How the corporation uses its assets is also a determining factor for QSBS status. During the stockholder’s minimum five-year holding period at least 80 percent of the corporation’s assets must be used in the active conduct of a qualified business. Such asset uses include startup activities, qualifying research and experimental expenditures, and in-house research expenses. Assets may also be held for investment if expected to be used for research and experimentation within two years. These allowances are especially favorable to startups as they help new businesses meet the 80 percent asset use test through activities in the furtherance of future revenue.
A startup can make furniture, beer or soap and issue QSBS, but there are a number of activities that do not meet the qualified small business rules, including: accounting, architecture, consulting, engineering, financial, health, legal, or performing arts services, among others; banking, finance, insurance, investing, or similar pursuits; farming; and hotel, restaurant and similar hospitality businesses.
If all QSBS criteria are met, the next step is to determine the amount of potential income that can be excluded. For QSBS acquired after Sept. 27, 2010, and before Jan. 1, 2014, then held for the minimum of five years, 100 percent of the gain on the sale or exchange of the stock is excludable from taxable gross income. The 100 percent exclusion is, like nearly everything in taxes, subject to some limitations. For each tax year, and for each QSBS corporation, the excludable gain can be no more than the greater of the following two amounts: $10 million, less any QSBS gain from the same corporation excluded in prior years, or 10 times the stockholder’s total adjusted QSBS basis in the same corporation in the tax year.
If, for example Dan has $500,000 of basis in QSBS sold for $12 million, he can exclude $10 million of the $11.5 million gain in the year of sale. This $10 million is greater than $5 million, which is 10 times his QSBS basis of $500,000. The reminder of the gain that is not excluded would be taxed at the applicable capital gain rate, and may also be subject to the additional 3.8 percent health care tax on investment income.
Additionally, if Dan realized a $2 million gain on QSBS of the same corporation in the prior year he would be able to exclude only $8 million in the current year, as the $10 million limitation is cumulative for QSBS of the same corporation. More than $10 million can be excluded, however, if 10 times Dan’s basis in the QSBS is greater than $10 million. Planning possibilities include selling portions of the total QSBS over several years to maximize each year’s excludable gain.
With the 100 percent gain exclusion set to expire at the end of 2013, some current holders of non-qualified small business stock might be tempted to find ways to “wash” the holdings into qualifying stock. The tax code, anticipating such nefarious schemes, includes prohibitions against corporations buying from and then reselling its stock to the same or related persons. If it’s not QSBS stock right now, you cannot turn it into QSBS by the end of the year.
The 100 percent QSBS gain exclusion is valuable to both family business entrepreneurs and investors. For those starting a business, the gain exclusion can be a tool for attracting capital and the provisions are favorable to research, development and similar activities of a new venture. Investors, moreover, have the opportunity for greater reward relative to investment risk when gains are excluded from taxable income.
In the context of a successful enterprise, issuing or investing in QSBS during the remainder of 2013 could lead to business growth and a tax-free payoff in the future.
Jeff Sayers is a tax senior associate and Richard Noreen is a partner with the local office of BDO USA LLP.