Fiscal Cliff Deal Reinstates 100% Exclusion For Gains on Sale of Shares Issued by Most Start-Ups.

Capital gains dispositions on "qualified small business stock" (“QSBS”) are once again temporarily 100% exempt from federal taxation under Section 1202 of the Internal Revenue Code. Historically, under Section 1202 a taxpayer (other than a corporation) that recognizes gain from the sale or exchange of QSBS shares held for more than five years could exclude 50% of such gain from gross income for regular income tax purposes.  Generally, however, such gain was included in alternative minimum tax (“AMT”) calculations, which could claw back much of the exclusion in the right (or wrong) circumstances.  As part of recent legislative and executive branch efforts to stimulate the economy, the Section 1202 exclusion was raised from 50% to 75% for QSBS shares acquired during most of 2009 and 2010. Then in September 2010, the Small Business Jobs Act of 2010 was enacted, further amending Section 1202 to exclude 100% of qualifying gain from gross income.  It also excluded all of the qualifying gain from AMT calculations.

This increased exemption expired on December 31, 2011, with the result that the exemption was returned to the historic 50% amount for QSBS acquisitions completed thereafter.  Several abortive attempts were made in late 2011 and early 2012 to reinstate the 100% exemption, though none were successful.  Under the 2012 American Taxpayer Relief Act (the "ATRA"), however, which was adopted in early January, 2013 in connection with efforts to avoid the "fiscal cliff," the 100% exclusion was retroactively reinstated for acquisitions of QSBS shares effected in 2012 and extended for acquisitions completed by the end of 2013.  Also reinstated is the 100% exclusion of the gain for purposes of AMT calculations, which means that in most instances gains on sales of QSBS shares held for 5 years will be completely tax free, subject to certain dollar thresholds discussed below.

Under Section 1202, "QSBS" shares are shares issued in exchange for cash, assets or services directly to the acquirer by a C corporation that meets certain requirements – which will encompass most startups. These requirements include (i) that the qualifying corporation's total gross assets must not exceed $50 million, (ii) the corporation must be engaged in the active conduct of a trade or business (excluding certain businesses, such as most service business, as well as banking, investing, farming and  mining entities, and companies operating restaurants or hotels), and (iii) the corporation must not have engaged in certain prohibited redemptions in the prior 2 years, among other restrictions.

To qualify for the capital gains exclusion, the QSBS shares must be held for at least five years before disposition.  The amount of the exclusion for an investment in a particular corporation is limited to the greater of $10 million or 10 times the acquiror’s adjusted basis of the QSBS.  Thus, the first $10 million in gain on dispositions of a founder’s shares acquired for $100 would be tax free, as would the first $50 million in gain on shares acquired by a (super) angel or VC firm for $5 million. In certain circumstances, such as tax-free mergers and Section 351 transactions (which involve contributions of shares and assets into another corporation), gain on qualifying 1202 securities may be rolled over into new QSBS shares and deferred until a future disposition.

While most of the Section 1202 provisions have remained unchanged from prior law, one significant change in ATRA is a modification of the method for determining when stock is "acquired" for purposes of Section 1202.  Under the new rules, if the holding period of newly issued stock is tacked onto a taxpayer's holding period for other securities that were exchanged for the stock, then the "acquisition date" of the stock will be the beginning of the earlier holding period. Therefore, if previously acquired QSBS shares are exchanged for shares of a new QSBS qualifying entity, or a qualifying LLC interest is converted into QSBS shares, the holding period of the prior QSBS shares or LLC interest counts towards the five year minimum holding period, so long as the original interests were acquired after September 28, 2010.  

I expect that the reinstatement of the 100% exclusion of Section 1202 will increase interest in investments in qualified small businesses in 2013.  Founders, angels and other startup investors should seek, where possible, to structure their investments to take advantage of this exclusion.  Additionally, owners of existing small businesses seeking additional investments should consider reorganizing in ways that will allow their investors to take advantage of the exclusion, which could make their company more attractive to potential investors.  After all, who doesn’t like completely tax-free gains?  All parties, however, should be mindful that the opportunities presented by Section 1202 require thoughtful planning. So as always, consult with your friendly neighborhood startup lawyer.