Gains on sales of QSB stock in light of secs. 1045 and 1202.

Two Code provisions offer opportunities to defer or exclude gains on the sale or exchange of qualified small business (QSB) stock. Sec. 1202 provides a partial exclusion of gain and, under Sec. 1045, gain is deferred when the proceeds of a QSB stock sale are reinvested in other QSB stock.

Overview

Under Sec. 1202(c), (d)(1) and (e)(4), QSB stock is any stock in a QSB originally issued after Aug. 9, 1993 (the enactment date of the Revenue Reconciliation Act of 1993). A QSB is any domestic C corporation other than a domestic international sales corporation (DISC) or former DISC, a regulated investment company (RIC), a real estate investment trust, a real estate mortgage investment conduit, a cooperative, or a corporation that has elected the Puerto Rico possession tax credit under Sec. 936 and whose aggregate gross assets did not exceed $50 million both before and immediately after the issue date. In addition, the corporation's gross assets cannot have exceeded $50 million at any time after Aug. 9, 1993, and at least 80% of the value of its assets must be used in a qualified trade or business; see Sec. 1202(d)(1) and (e)(1).

Under Sec. 1202(e)(3), a "qualified trade or business" is any trade or business other than health, law, engineering or architectural services, etc., or any other trade or business whose principal asset is the reputation or skill of one or more of its employees. Also excluded from the definition are banking, insurance, financing, leasing, investing or similar businesses; farming; mineral extraction; and the operation of a hotel, motel, restaurant or similar business. Under Sec. 1202(c)(2)(A), this active business requirement must be met for substantially all of the stockholding period. Finally, to qualify as a QSB under Sec. 1202(d)(1)(C), the corporation must agree to any IRS reporting requirements.

Under Sec. 1202(c)(1)(B), QSB stock must be acquired at its original issue for money or property (other than stock), or as compensation directly for services provided to the QSB (other than those of an underwriter of the stock). A taxpayer who acquires QSB stock by gift or inheritance or from a partnership distribution is treated as having acquired it in the same manner as the transferor and has to include the transferor's holding period in calculating eligibility for the Sec. 1202 exclusion. A partnership may distribute QSB stock to its partners, as long as the partner held its partnership interest when the QSB stock was acquired by the partnership; see Sec. 1202(h).

Gain Exclusion

For taxpayers other than corporations, Sec. 1202(a)(1) excludes 50% of any gain from the sale or exchange of QSB stock held for more than five years. Sec. 1202(b)(1), however, limits the exclusion to the greater of $10 million or 10 times the stock's adjusted basis. This limit is on a per-issuer--not on a per-transaction--basis. For investments in a QSB acquired after Dec. 21, 2000, in which the QSB qualifies as an empowerment-zone business under Sec. 1397C(b) for substantially all of the holding period, the gain excluded under Sec. 1202 is 60%; see Sec. 1202(a)(2).

Under Regs. Sec. 1.1202-1(a), the tax rate on the nonexcluded gain on a QSB stock sale is 28%. As the current long-term capital gain rate is 15%, the gain exclusion under Sec. 1202 generally does not provide a significant Federal income tax benefit. Further, a portion of the excluded gain is a tax preference item, so the benefit of the exclusion may be further reduced; for QSB stock sales or exchanges after May 5, 2003, 7% of the excluded gain is deemed a tax preference item and added back to taxable income in calculating alternative minimum taxable income. The 7% tax preference was adjusted by the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA); see Sec. 57(a)(7). Like many JGTRRA provisions, it will sunset after 2010. Afterward, the tax preference percentage will revert to 42% of gain excluded, which will further reduce, if not eliminate, the benefit of the Sec. 1202 exclusion. Unlike a rollover of gains on a QSB sale or exchange under Sec. 1045, the application of Sec. 1202 is required, not elective.

Under Sec. 1202(g)(2), gain on qualified stock held by a pass-through entity (e.g., a partnership, S corporation, RIC and common trust fund) is excludible if the entity held it for more than five years and if the partner, shareholder or participant to whom the gain passes through held an interest when the entity acquired the stock and at all times thereafter. The gain excluded by each partner, shareholder or participant is limited to the extent that its share in the entity's gain on the disposition of the QSB stock is greater than its share of the entity when the QSB stock was acquired; see Sec. 1202(g)(3).

Gain Deferral

Congress added Sec. 1045 in 1997. Under this provision, gains on QSB stock sales can be deferred if the proceeds are reinvested in replacement QSB stock purchased during a 60-day period that begins on the date of the QSB stock sale; see Sec. 1045(a). Generally, QSB stock under Sec. 1045 has the same definition as QSB stock under Sec. 1202; however, only a six-month holding period applies to QSB stock sold and reinvested under Sec. 1045; see Sec. 1045(b)(1) and (a). In addition, under Sec. 1045(b)(4)(B), the QSB must have met the active business requirement for only the first six months following the QSB stock acquisition.

If the proceeds from the sale of QSB stock are reinvested in replacement QSB stock, gain is only recognized to the extent the reinvested amount is less than the amount realized on the sale or exchange of the original QSB stock. Recognized gain is limited to realized gain; see Sec. 1045(a). Under Sec. 1045(b)(4), the holding period in the replacement stock includes the holding period in the original QSB stock. The deferred gain on the QSB stock sale serves to reduce the basis in the replacement QSB stock. The election to defer gains on QSB stock sales is made on a timely filed return, including extensions, for the year in which the QSB stock is sold; see Rev. Proc. 98-48 for election procedures.

Interaction between Secs. 1045 and 1202

As the criteria for qualifying as QSB stock under Secs. 1045 and 1202 are extremely similar and the only significant difference between them is the holding-period requirement, gains on a QSB stock sale or exchange may qualify under both provisions. Nothing prevents a taxpayer from claiming both a Sec. 1045 deferral and a Sec. 1202 exclusion on the same disposition of QSB stock. Further, no authority shows how to order the rules. Thus, the application of these two Code sections can give different results, depending on the circumstances; see Example 2 at right.

Example 1: In 2005, taxpayer T sells stock of QSB Q Corp., with a $500,000 basis, for $1.5 million, resulting in a $1 million gain. T pays 15% tax on long-term capital gains. She has held Q for more than five years. T reinvests the entire proceeds in stock of QSB R Corp. within 60 days and, thus, is eligible for a Sec. 1045 rollover (the state tax benefit of treating the gains under Sec. 1045 or 1202 are not considered here).

If T elects Sec. 1045 treatment, she can defer the entire gain, and her basis in her R stock is $500,000 (carryover basis). T's holding period in R stock includes the period she held Q stock. The Sec. 1045 rollover reduces T's 2005 Federal tax liability by $150,000 ($1,000,000 x 15%, not taking into account the Sec. 1202 exclusion) or $140,000 ($500,000 x 28%, taking the Sec. 1202 exclusion into account (see below)).

If T does not elect Sec. 1045 treatment, 50% of the gain on the Q stock sale ($500,000) is excluded in calculating the capital gain. T's basis in R stock is $1. 5, million; the holding period for T's investment in such stock begins on the date she acquired it. The nonexcluded portion of the Sec. 1202 gain is taxed at 28%. As a result, T is subject to a $140,000 tax liability on the sale and, in claiming the Sec. 1202 exclusion, she would save $10,000 in tax.

If T were subject to the alternative minimum tax (AMT), the Federal tax savings on the QSB stock sale under Sec. 1202 would be further limited, as 7% of the excluded gain ($35,000) would be a tax preference item. Accordingly, the Federal tax would be $149,800 ($500,000 taxable gain + $35,000 AMT preference x 28% tax on Sec. 1202 stock). As such, T's Federal tax savings due to the exclusion would be reduced to $200.

Example 2: The facts are the same as in Example 1, except T reinvests in R stock $750,000 of the proceeds on the sale of the Q stock.

If gains are deferred first under Sec. 1045 and the amount recognized is eligible for the Sec. 1202 exclusion, the following results:

Gain on the Q stock sale          $1,000,000
Less: Gain deferred under
  Sec. 1045                           250000
Gain eligible for the Sec. 1202
  exclusion                         $750,000
Less: Sec. 1202 exclusion (50%)      375,000
Taxable gain                        $375,000
Tax rate                              x 0.28
Federal tax on gain                 $105,000

Basis in R stock = $500,000

Note: 7% of the Sec. 1202 exclusion, or $26,250, is
a lax preference item.

If gains are first excluded under Sec. 1202, and the nonexcluded amount is eligible for a Sec. 1045 rollover, the following results:

Gain on the Q stock sale          $1,000,000
Less:Sec. 1202 exclusion (50%)       500,000
Gain eligible for the Sec. 1045
deferral                            $500,000
Less: Sec. 1045 gain deferred        250,000
Taxable gain                        $250,000
Tax rate                              x 0.28
Federal tax on gain                  $70,000

Basis in R stock = $500,000

Note: 7% of the Sec. 1202 exclusion ($35,000) is a
tax preference item.

State Tax Considerations

In addition to the Federal tax benefits available from Secs. 1045 and 1202, there are state tax benefits as well, which may far outweigh the Federal tax benefits due to the effect of the AMT. If a taxpayer is subjected to AMT for Federal tax purposes, the effective tax rate on Sec. 1202 gains is 14.98% (50% exclusion + 7% of exclusion x 28% rate on Sec. 1202 gain), providing a minimal Federal tax benefit from the 15% rate that would otherwise apply to long-term capital gains. However, in states in which taxes are based on Federal adjusted gross income (AGI) and there is no state AMT system (such as Ohio), the Sec. 1202 exclusion, or 50% of the gain recognized, could have a much greater effect. Again, in a state such as Ohio, where the maximum tax rate is approximately 7.5% and there is no preferential rate on long-term capital gains, the taxpayer realizes approximately a 3.75% savings at the state level, as compared to the 0.02% Federal savings. As many states (similar to Ohio) base their calculation of taxable income on Federal AGI and do not require a state tax adjustment for the Sec. 1202 exclusion or the Sec. 1045 deferral, amounts excluded under Sec. 1202 or deferred under Sec. 1045 may significantly reduce the taxpayer's state tax liability. Tax advisers should carefully weigh the effect of the two provisions on the taxpayer's state tax liability and reporting position.

Conclusion

Given the different tax consequences of applying Sec. 1045 and/or 1202 to a particular transaction, tax advisers should exercise caution and be aware of the potential planning techniques available to maximize their clients' potential tax benefits.

FROM ROBERT A. VELOTTA, CPA, MT, COHEN & COMPANY, LTD., CLEVELAND, OH