pic-asher.jpgCONTRIBUTED BY
Asher Bearman


**UPDATE** The QSBS stock exclusion discussed below has been extended through December 31, 2011.  Read more here.

Last month, Congress passed a temporary 100% tax exclusion for gains on Qualified Small Business Stock (“QSBS”) for capital gains and alternative minimum tax (“AMT”) purposes.  Although it is now a month old, we’re still getting a lot of questions about it so I think a blog post is in order.

WHO:  Investors in startup C corporations.

WHAT:  100% tax exclusion on gains from QSBS.

HOW:  Acquire QSBS after September 27, 2010 and before January 1, 2011 and hold the stock for at least 5 years.

If you are closing an investment in the next couple of months that could qualify for QSBS treatment, take special care to find out whether it qualifies for QSBS treatment.  If it does, consider closing before the end of the year, if possible, and be as sure as possible can that the company’s stock will qualify for the exclusion (i.e., make sure that the legal documentation in connection with your investment includes good representations as to the QSBS qualification and covenants to ensure the the company complies with ongoing QSBS reporting requirements.

Revised Internal Revenue Code Section 1202 generally includes the following requirements:

  • The stock must be newly issued by a C corporation that operates an active business (rather than a service business)
  • The corporation’s asset do not exceed $50,000,000 in value
  • The corporation agrees to submit necessary reports to the IRS (possibly an administrative pain for a startup)
  • Corporate investors do not qualify for the exclusion – only individuals qualify (including individuals investing directly through a pass-through partnership or LLC).

Much has been written about the new legislation in the past month, including at startuplawblog.com, but I wanted to provide a little more context on exactly what this law is as compared to prior law.

The QSBS exclusion has been in place since 1993 – however, it has historically been of little utility to investors because the exclusion was based on the 1993 effective capital gain tax rate of 28% (meaning that a 50% exclusion still resulted in a 14% effective rate).  For some reason, this was not pegged to the applicable long term capital gains rates.  The current 15% long term capital gain rate makes a 14% rate almost meaningless, particularly since the AMT often eliminated the benefit.  In 2009, the 50% exclusion was temporarily increased to 75%, which provided a meaningful reduction for capital gains purposes, but this change is no longer relevant applicable.

The September 27, 2010 legislation gives a short window of opportunity.  It seems likely that this incentive will pass before many investors can take advantage.  Assuming no further legislation, the QSBS exclusion will go back to 50% (or a 14% effective tax rate) in 2011.  Reading the tea leaves, it seems as though more is in store here.  Congress has been active in this area in the past few years (2 temporary pieces of legislation in 2 years).  As a result, I am cautiously optimistic that January 1, 2011 will not be the last bite at the apple.  If you can qualify now, definitely look into it and protect yourself (as noted above and by talking to your lawyer).  If not, keep watching for possible additional QSBS extensions or incentives in the coming months.