The exclusion from gain applicable to the sale of qualified small business stock (“QSBS”) is a key benefit in selecting C corporation status for startups and other businesses. QSBS stock allows the noncorporate taxpayer to exclude from gain the greater of $10 million or ten times the taxpayer’s basis in the stock (“QSBS Eligible Exclusion Amount”). Properly excluding this gain from tax is an important tax savings opportunity and significantly increases the noncorporate taxpayer’s return on investment.
To be eligible for QSBS treatment, the taxpayer must have held the stock for more than five years, the stock must have been acquired at its original issue, it is stock of a C corporation, the company is a qualified small business, and meets an active business requirement.
For QSBS stock acquired after February 17, 2009, and on or before September 27, 2010, the exclusion from gain is 75 percent of the QSBS Eligible Exclusion Amount, and for stock acquired after August 10, 1993, and on or before February 17, 2009, the exclusion from gain is 50 percent of the QSBS Eligible Exclusion Amount. This is important background information to understand how, and to which gain the 28 percent tax rate is applicable.
Many tax professionals believe any gain that is recognized on QSBS stock is taxed at a long-term capital gains tax rate of 28 percent. This is not the case and we have seen a number of examples where taxpayers significantly overpaid tax by having their gain over the QSBS Eligible Exclusion Amount taxed at 28 percent.
The 28 percent long-term capital gains tax rate is only applicable to gain which would be excluded from gross income under Internal Revenue Code (“IRC”) §1202 but for the percentage limitation (“1202 Gain”). The 28 percent capital gains tax rate would only apply to QSBS stock acquired prior to September 28, 2010, to the extent of the 1202 Gain. Since 100 percent of the QSBS Eligible Exclusion Amount is allowed for QSBS stock acquired after September 27, 2010, no gain on the sale of this stock would be subject to the 28 percent long-term capital gains tax rate.
We reviewed a tax return prepared by another tax professional where the client recognized about $40 million of gain on the sale of QSBS stock. The tax professional properly excluded $10 million from taxation and erroneously taxed the balance of the gain at the 28 percent tax rate, which when added with the net investment income tax (“NIIT”) at 3.8 percent, resulted in federal income tax of $9,540,000. Whereas the tax on the sale of the stock should have been taxed at the regular long-term capital gains tax rate of 20 percent, which when added with the 3.8 percent NIIT, would result in an income tax of $7,140,000. The incorrect reporting of this gain almost cost this client $2.4 million in erroneous tax.
In addition to understanding the QSBS Eligible Exclusion Amount, it is essential that the professional advisers understand what gain is subject to the 28 percent tax rate, how the balance of the gain is taxed, and be able to execute this reporting on the appropriate tax forms. For these transactions that create large gains, it is important to have a team that can ensure the proper tax is paid. The consequences are too significant to get it wrong.
Praestans Global Advisors is neither a law firm nor a CPA firm.