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Who’s Up for Tax-Free Capital Gains?

Posted on May 11th, 2013

From the editor:  We saw many companies raising capital in 2010 and 2011 to take advantage of the tax relief under Section 1202 of the Internal Revenue Code to give investors the potential for tax-free gains if they held the stock for the required 5 years and the company met certain conditions.  While that relief went away in 2012, recent tax law enactments have brought back this tax treatment for 2012 and 2013. We would like to thank our tax colleague Travis Blais from Travis Blais & Co.  for preparing the following post on this topic:

Most of us know that the American Taxpayer Relief Act of 2012, better known as the “fiscal cliff bill,” extended lower across-the-board tax rates, including those for dividends and long-term capital gain, for all but a handful of taxpayers.  Less well known is that the ATRA extended many business tax benefits, including the possibility of tax-free capital gains for “qualified small business stock” (QSBS).

Tax-free?  Yes.  QSBS is potentially the ultimate tax bargain – QSBS acquired through the end of 2013 and held for 5 years will incur 0% capital gains tax upon eventual sale. Of note, QSBS was extended retroactively, meaning stock previously acquired in 2012 as well that acquired in 2013 may qualify.

As you would expect, this kind of benefit comes with a lot of conditions.  The stock must be of a domestic C corporation, purchased at original issue for money, property other than stock, or services.  As a shareholder, a C corporation itself is not eligible for the tax-free treatment.  The tax-free gain is limited to the greater of “10x” (10 times one’s investment) or $10 million.  To be a “qualified small business,” the issuing corporation must never have had assets greater than $50 million either before or immediately after the stock purchase.  Moreover, 80% of the corporation’s assets must be used in a qualified trade or business, which excludes professional services, finance, farming, mining, or hospitality.For many investors, the most daunting requirement is that stock must be held for at least five years to qualify for the 0% rate.  In this regard, it is helpful that QSBS can be “rolled over,” that is, sold and its proceeds used to purchase different QSBS, deferring capital gains recognition and “tacking” the holding periods in hopes of crossing the five-year finish line.The obvious opportunity to acquire QSBS is upon the startup of a new business or a venture capital investment in an existing, small corporation.  But be on the lookout for less evident QSBS situations.  For instance, LLCs could be converted to corporations, particularly in anticipation of an investor financing that might require such a conversion anyway.  Investors might be holding stock rights in the form of options or convertible debt that could be exercised into stock.  Or QSBS may be available in newly formed shell corporations created to pursue a reverse acquisition.

Travis Blais