The 100% Qualified Small Business Exclusion

In a little noted but hugely significant provision of the American Taxpayer Relief Act of 2012 (“ATRA”), Congress has extended the 100% exclusion from tax for gains from the sale of Qualified Small Business Stock (QSBS) held for more than 5 years. Although it seems to have come as an afterthought, the QSBS exclusion may be one of the bigger job creators in the bill. Under the extension, up to $10 million of gain from QSBS purchased in 2010 – 2013 is exempt from tax, including alternative minimum tax (“AMT”).

As described in a previous blog post, QSBS includes originally issued stock in a C corporation that conducts an active trade or business and has less than $50 million of gross assets at the time of issuance.  See Valuable QSBS Opportunity for Investors and LLC’s to End on December 31, 2011.

The new provision could have a big tax effect – taxpayers who are not being taxed at a federal rate of as high as 39% (with state rates, one of the highest in the world) have a path for avoiding tax entirely on the gains from startup company investments. The bad news (for Californians) is that this change in the law comes at a time when California’s Franchise Tax Board (FTB) has determined that there simply is no QSBS exclusion for California income tax purposes (not even a rollover). While the long term viability of the California rule is doubtful, the federal tax law change makes startup investing that much more attractive.

As a planning matter, the QSBS exclusion complicates the choice of entity decision. Generally, limited liability companies (LLCs) and S corporations are favored forms of entity because their earnings are subject to only one level of tax (once at the owner level) whereas a C corporation’s earnings are subject to two levels (once at the corporate level and again at the shareholder level when the earnings are distributed). The distinction is somewhat illusory, however, because even a QSB must pay corporate taxes at the corporate level on its corporate income. Nevertheless, if the exit is a stock sale before the company hits profitability, the new rule makes the tax stakes a little less clear (i.e. trading one level of tax at the corporate level (QSB) for one level of tax at the owner level (LLC or S corp)). Unfortunately, there will be no one size fits all solution, and tax will be one factor in the equation.

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Roger Royse
rroyse@rroyselaw.com

Roger Royse, the founder of the Royse Law Firm, works with companies ranging from newly formed tech startups to publicly traded multinationals in a variety of industries. Roger regularly advises on complex tax structuring, high stakes business negotiations and large international financial transactions. Practicing business and tax law since 1984, Roger’s background includes work with prominent San Francisco Bay area law firms, as well as Milbank, Tweed, Hadley and McCloy in New York City.
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