Qualified Small-Business Stock

A special tax break is designed to help qualifying small C corporations raise capital by allowing long-term noncorporate investors in original issue stock to cut the tax on their profit. The investor must hold the stock for at least five years to take advantage of this exclusion of gain on the sale. Moreover, the amount of the gain varies depending upon when the stock was acquired.

In order to qualify for this special break, taxpayers must jump through a large number of hoops. But the amount of tax saved--especially for higher-income taxpayer and those who face the new 3.8 Medicare tax on net investment income can be significant.

The capital gains exclusion applies only to gain on eligible stock (1) originally issued by a qualifying corporation after August 10, 1993, and (2) held for more than five years. The highlights of this break follow:

• The stock must be acquired in an exchange for money or other property (other than stock), or as compensation for services provided to the corporation (other than acting as the stock's underwriter).
• The small business must be a regular C corporation; it must have $50 million or less in aggregate capital as of the date of stock issuance; and at least 80 percent by value of corporate assets must be used in the active conduct of one or more trades or businesses.
• The corporation cannot be involved in the performance of personal services (such as health or law) or in the finance, banking, leasing, real estate, farming, mineral extraction, or hospitality industries. A number of other types of businesses, such as mutual funds and REITs, are also disqualified.
• The exclusion for each eligible corporation applies only to the extent that the gain does not exceed the greater of (1) 10 times the taxpayer's adjusted basis in the stock disposed of during the tax year (post-issuance additions to basis are disregarded), or (2) $10 million ($5 million for marrieds filing separately), reduced by gain excluded in earlier years from sales of stock in the corporation.
• Although a post-issuance purchaser of otherwise qualified stock doesn't get the exclusion, the tax break is preserved for those who receive such stock as a gift or due to the death of the original purchaser. The transferor's holding period also carries over to the transferee. Similar rules apply to qualified stock distributed by a partnership to its partners.
• Individuals can roll over, tax-free, gain realized on the sale or exchange of qualified small business stock provided that the proceeds are used to purchase other qualified small business stock within 60 days of the sale.

If a sale of stock qualifies for the exclusion, the remaining gain is not eligible for the regular long-term capital gains rate that applies to assets held for more than 12 months. Such gain is taxed at a maximum rate of 28 percent. However, if the exclusion does not apply because the stock is sold prior to the expiration of the required five-year holding period, the entire gain qualifies for taxation at the regular capital gains rate.

Tip Beginning in 2013, a new 3.8 percent net investment income tax may be imposed on individuals whose modified adjusted gross income exceeds $250,000 for joint filers, $125,000 for married taxpayers filing separately, and $200,000 for others. Trusts and estates with income over a certain amount are also subject to the NII tax. Form 8960, Net Investment Income Tax - Individuals, Estates, and Trusts is attached to the tax return. For 2013, the IRS has provided taxpayers the ability to rely on more than one set of net investment income tax rules. The best choice varies by taxpayers and depends on the taxpayer's unique situation. Consult your advisor to determine which approach would be best for you.

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