Qualified Small Business Stock --Fine print considerations

By Dan Wright dwright@clarknuber.com Clark Nuber P.S. December 7, 2011
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Overview
• 2011 stock gain examples – Other examples highlight recent changes that apply to future transactions – Critical dates for planning acquisitions/dispositions Definition: “qualified small business” Definition: “qualified small business stock” Commonly asked questions Questions from participants Planning considerations

• • • • •

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Example 11998 investment/2011 sale
• • • • • In 1998, A acquired StartFast stock. In 2011, A sells StartFast stock. All of the QSBS rules are satisfied-A realizes $100,000 of gain on sale. A has no capital losses or capital loss carry-forwards in 2011.

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2011 Example – Regular tax
Excluded Gain Tax rate Tax Total tax $50,000 0% Included $50,000 28% 14,000 $14,000

Total gain
Effective tax rate

$100,000
14.00%

1% rate savings ($1,000) compared to the current 15% tax rate
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Applicable Exclusion %
---(Regular tax):

• Stock acquired:
– August 11,1993 through February 17, 2009 -- 50% – February 18, 2009 through September 27, 2010 -- 75%. – September 28,2010 through December 31, 2011 – 100% – Post December 31, 2011--- 50%

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75% exclusion example (acquired 2/18/2009 through 9/27/2010)
Excluded Gain Tax rate Tax $ 75,000 $ 0% $ Included 25,000 28% 7,000

Total tax Total gain
Effective tax rate

7,000 100,000
7.00%

8% rate savings compared to 20/25%? LTCG rate

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How Alternative Minimum Tax (AMT) is calculated

Taxable income (per regular tax system) +/- preference/exclusion items AMTI before exemptions - Exemptions (subject to phase out limits) AMTI AMT rate: Either 26% or 28% AMT

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Special AMT temporary rule:
• For taxable dispositions occurring after May 5, 2003 and before January 1, 2013:
– A special 7% preference rate applies (i.e., 7% of the amount excluded for regular tax purposes is included in AMTI) – Effectively, 46.5% is excluded.

• When this rule sunsets, the AMT exclusion will be 36%
– (28% inclusion rule will generally apply.)
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2011 example-AMT
• Same facts as before • Assume the 28% AMT bracket applies. • “Preference item” of 7% times the regular tax exclusion amount is added back to AMTI. (i.e., for a total inclusion of $53,500)
– $50,000 plus (7% of excluded $50,000)

• A 28% AMT capital gain rate applies • AMT on gain is $14,980, or 14.98%
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2011 Example - Alternative Minimum Tax (7% inclusion) Excluded Gain Tax rate Tax Total tax Total gain Effective tax rate $ 46,500 0% Included $ 53,500 $ 100,000 28% 14,980 14,980 100,000 14.98%

$

.02% rate break – effectively no benefit (compared to the 15% AMT LTCG rate)
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75% exclusion - Alternative Minimum Tax (7% inclusion) Excluded Gain Tax rate Tax Total tax Total gain Effective tax rate $ 54,000 0% Included $ 46,000 $ 100,000 28% $ 12,880 12,880 100,000 12.88%

Rate is lower --- Some benefit (compared to the 20/25% AMT LTCG rate)
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Qualified Small Business -Definition fine print

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What is a “qualified small business”?
1. Tax status of entity: “C corporation” 2. “Aggregate gross asset” test 3. “Active trade or business” test

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2. Aggregate Gross Assets (AGA)Test
• AGA can not exceed $50 million during the testing period. • Testing period:
– Begins: August 11, 1993 (or inception if later) – Ends: Immediately after investment (i.e. investment is counted).

• How AGA is measured: The sum of:
1. Cash 2. Adjusted bases of all other property held by the corporation. 3. Contributed property:
• measured by FMV at the time of the contribution.

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3. “Active trade or business” test
• 80% of the assets (measured by value) must be used in the active conduct of a “qualified trade or business”.
– Assets used in the following are considered active business assets:

• Start up activities • Research and Experimental activities
– Working capital and investments expected to be used within 2 years to finance R&D or working capital needs are treated as used in an active trade or business. – IP rights to computer software royalties are considered as an active business asset.

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3. “Active trade or business” test (cont.)

• Period tested: During “substantially all” of the investor’s holding period, the corporation must meet the active trade or business requirement. • Prohibited holdings.
– >10% of total assets is stock or securities (not subsidiaries) – > 10% of total assets is real estate (not used in active business)

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3. “Active trade or business” test (Cont.)– Qualified trade or business definition:
• Any trade or business other than: – Service businesses • i.e., health,law,engineering,architecture, accounting, actuarial science,performing arts, consulting,athletics, financial services, brokerage services,etc. • Any business where the principal asset is the reputation or skill of its employees. – Banking, insurance, financing, leasing, etc. – Farming – Mining/extraction – Hospitality, i.e., hotel, restaurant, etc.
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Qualified Small Business (QSB) Stock --Special requirements

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How QSB stock is defined:
1. Must be original issue stock 2. Exchanged for:
– – – Cash Other property Services (other than as an underwriter).

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Holding period rules:
• Must be held for 5 years before disposition • Stock acquired by conversion of other corporate stock: Holding period of original stock tacks on to newly acquired stock. • Stock acquired by contributing property: Holding period begins on the date the stock is received.
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Redemption trap #1: Only disqualifies specific investor stock:

• If the corporation redeems any stock from the investor (or related party) during the 4 year period:
– Beginning 2 years before the acquisition – Ending 2 years after the date of acquisition

• Then, the none of the acquired stock qualifies as QSB stock.

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Redemption trap #2: Disqualifies the whole round of stock:
• If the corporation redeems any stock during the 2 year period: – Beginning 1 year before issuance – Ending 1 year after issuance • Then, the none of the acquired stock qualifies as QSB stock. • De minimis rule: – Rule doesn’t apply unless the stock repurchased exceeds 5 percent of the aggregate value of all outstanding stock at the beginning of the 2 year period, and – The repurchase price exceeds $10,000.
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Redemption rule exceptions:
• Certain redemptions are disregarded:
– Purchases from a retiring employee or director, an estate of a deceased shareholder – Purchases from a shareholder that is:
• Disabled, mentally incompetent, or divorcing.

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Common tax planning questions

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Question: Is there a limit on the excludable gain?
• Yes – The gain is limited to the greater of:
– $10 million (reduced by gain recognized on issuer stock in prior years), or – 10 times the original basis of the stock sold during the year.

• Example: If the stock is purchased for $100,000, and sold for $20,000,000, the exclusion is $5,000,000 (50% of $10,000,000). • Limit is the same regardless of marital status, but different for married filing separate.
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Question: Can I offset QSB stock gains (the taxable portion) with other capital losses?
• Answer: Yes, capital losses for the year and capital loss carry forwards from prior years first offset the 28% rate gain category which includes QSBS gain for the year.
• If you have depreciated capital gain property and are considering disposition –timing the loss offset your QSB stock gain is a good way to get 28% a tax benefit (v. 15%).

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Question: How long do I have to hold the stock in order for it to qualify?

• Answer: It depends on how you acquire the stock.
– If you acquired the stock directly from the issuing corporation, 5 years. – If you acquire the stock by gift or inheritance, then you also include the time held by the party you received it from. – If you received it as a distribution from a partnership, you may be able to include the time the stock was held by the partnership.
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Question: What if I contribute property in exchange for stock – what is my basis in the stock for purposes of the gain limitation rules?

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Question: Can I redeem stock and then have it reissued later in order to take advantage of a new issue date?

• Answer: No, if any of your stock has been redeemed within 2 years prior/after the new issue date, it will disqualify the newly issued stock. • Redemptions within four years (beginning two years before the issue date) of any stock from the taxpayer or a related person will disqualify the issued stock.
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Question: Can I transfer an existing business into a new or existing corporation?
• If the business is a sole proprietorship, a partnership/LLC or an S corporation, and the FMV of the assets is less than 50 million, then you should be able to convert to a C corporation form and qualify the stock as QSB stock.
– Care must be taken to plan this transaction properly to avoid gain (i.e., relief of debt, etc.) when incorporating the business.

• Also, simply terminating an S corporation’s S status will not qualify as their would be no new C corporation stock issued. • If the business is in a C corporation already, then their may be little benefit. Gain may be trigger by transferring the assets to a new corporation. This should be evaluated carefully before proceeding.

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Question: How do the rules apply to Stock Options?
• Critical date: Date stock received, not the grant date, for determining the holding period, applying the AGA test, etc. • AMT holding period rule: – Stock acquired after December 31,2000, • by the exercise of an option that was granted before January 1, 2001 • The holding period begins on the date the option was granted – for this purpose only. • Thus, the higher 42% inclusion rule applies, verses the lower 28% rule.

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Question: Does preferred stock qualify as QSB stock?

• Yes, as long as the preferred stock qualifies as equity under current tax law, and all of the other requirements are met, it should qualify. • Note: Sometimes securities called “preferred stock” are treated as debt instruments under tax law. This type of instrument may not qualify for the exclusion provisions.
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Question: I hold preferred stock, what if I convert it?
• Answer: If the preferred stock is QSB stock, and is converted to other stock (i.e., common), the stock received upon conversion is also QSB stock. • The holding period of the converted stock shall tack onto the newly received stock.

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Question: What if I own a LLC interest that realizes gain on QSB stock?
• Answer: Your share of the gain should qualify for the exclusion rules if:
– The LLC’s holding period meets the 5 year rule – The LLC is treated as a partnership for tax purposes, – You were a partner when the stock was acquired by the LLC, and during all of the period the QSB stock was held by the LLC.

• Note: If your interest in the LLC has increased since the QSB stock was acquired, your qualifying gain will be limited to your share as of the date the QSB stock was acquired. • Similar rules apply to owners of other tax pass-through entities (i.e., S- Corporations, partnerships, regulated investment companies, and common trust funds).

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Your questions?

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Planning points:
• Track holding period and basis information carefully. • Make sure your advisor is well versed in the fine print. • Qualify target company before you invest to make sure they are a qualified small business. Make sure they can document their position in case of audit. • Offset QSBS gain that is not excludable with capital loss • Consider the conversion of an existing small business. • Make new investments before 12/31/2011.

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