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Investors in startups frequently require the corporation to warrant in connection with sale of its stock that the startup’s shares are qualified small business stock within the meaning of Section 1202 of the Internal Revenue Code (the Code). The reason is that Section 1202 allows a certain taxpayers to exclude from taxable income a portion of the gain realized on the sale of qualified small business stock. Section 1045 of the Code further allows certain taxpayers to defer recognition of potentially all such gain if the taxpayer reinvests in qualified small business stock within 60 days.
Under Section 1202 a taxpayer, other than a corporation, may exclude in general 50% of the gain realized on the sale of such stock if the taxpayer holds the stock for more than five years prior to sale, subject to adjustments for alternative minimum tax purposes. The gain excluded in this manner is limited, on a “per issuer” basis, to the greater of $10 million or ten times the taxpayer’s basis in the stock.
Qualified small business stock means any stock of a domestic corporation that is (i) a “qualified small business” upon issuance of the stock; and (ii) acquired by the taxpayer at its original issue for money, other property (not including stock), or as compensation for services. Stock acquired by the taxpayer will not be considered qualified small business stock if (i) the corporation buys any such stock from the shareholder or a related person within two years before or after issuance of the shares for which the exclusion is sought; or (ii) the corporation recovers more than 5% of the aggregate value of its stock within one year before or after issuance (with exceptions for certain events, such as death, divorce, disability, incompetency, and certain de minimis).
A “qualified small business” is a domestic C corporation, the gross assets of which through the issuance of the stock in question do not exceed $50 million (without regard to liabilities). The corporation must be an “active business,” and not simply an investment company. This means the corporation may not have (i) more than 10% of the value of its net assets consisting of stock and securities of other corporations (not including that of a subsidiary); or (ii) more than 10% of the total value of its assets not used in the active conduct of a qualified trade or business (which does not include the ownership of, dealing in, or rental of real property).
Gain from the disposition of qualified small business stock by a partnership or S corporation, that is allocated to the Capital account of a partner or shareholder is eligible for §1202 exclusion if the requirements of a qualified small business and qualified small business stock are met and if the taxpayer held its interest in the entity on the date the stock was attained until the stock’s disposition. To avoid the bypass of the holding period requirements, the amount of gain so excluded cannot exceed the amount determined by reference to the taxpayer’s pro-rata interest in the entity upon the acquisition of the stock.
A 60% exclusion is applicable if, in addition to meeting the requirements for the general 50% exclusion, the stock sold is acquired after December 31, 2000, in a qualified business entity (under empowerment zone rules).
Section 1045 allows a taxpayer, other than a corporation, selling “qualified small business stock,” to defer gain on such sale by rolling over the gain into a new investment in qualified small business stock. Rollover treatment under §1045 is possible if: (i) the taxpayer has held the original stock for more than six months; and (ii) the taxpayer makes a special election to claim §1045 treatment on his/her federal income tax return for the year of sale.
Deferral of gain under §1045 is available if the amount received upon sale does not exceed: (i) the cost of any new qualified small business stock purchased during the 60-day period after the date of such sale; reduced by (ii) any portion of such cost already used to harbor gain under §1045.
The application of these rules in any instance is complex and requires careful planning. Please contact your tax advisor to discuss how these rules apply to your situation.