Is the qualified small business stock exclusion worthwhile.

When enacted in 1993, Sec. 1202 seemed like a bargain--exclusion of 50% of the capital gain realized on the sale or exchange of qualified small business stock held for more than five years. However, with recent legislation's decrease in the capital gains rates and more taxpayers than ever subject to the alternative minimum tax, the exclusion is no longer the deal it seemed to be. This article explains why.

On Aug. 12,1998, the Sec. 1202 exclusion of 50% of the gain on qualifying small business (QSB) stock finally became fully operational. Sec. 1202 was added by Section 13113(e) of the Revenue Reconciliation Act of 1993 (RRA '93), effective for QSB stock issued after Aug. 10, 1993.

Sec. 1202's purpose is to encourage the investment in small, start-up companies that traditionally have difficulty raising capital. The incentive is provided to noncorporate shareholders who purchase QSB stock originally issued after Aug. 10, 1993 and hold it for more than five years. What are the actual tax savings provided Sec. 1202? This article demonstrates that a taxpayer does not save 50% of the tax liability; in some circumstances, he may even be worse off with the Sec. 1202 exclusion.

Overview

Sec 1202 places numerous and complex requirements on both the QSB and the shareholder. Under Sec. 1202(d)(1), the QSB's gross assets cannot exceed $50 million immediately after the stock issuance. Other restrictions apply throughout the holding period of the stock, including the following:

* The nature of the business (generally, not professional services, financial, farming, insurance, mineral extraction, restaurants or lodging), under Sec. 1202(e)(3).

* The percentage of assets (generally, at least 80% by value) devoted to the active conduct of the business, under Sec. 1202(e)(1)(A).

* The percentage of assets invested in other corporations (10% or less, unless they are more-than-50%-owned subsidiaries), under Sec. 1202(e)(5)(B).

* The redemption of stock, under Sec. 1202(c)(3).

Other restrictions, including the ability of a passthrough entity to hold the stock (Sec. 1202(g)) and shareholder transfer prohibitions (Sec. 1202(h)), apply at the shareholder level.(1)

Under Sec. 1202(a), if all of the requirements are met and the stock is held for more than five years, the noncorporate shareholder can exclude 50% of the sale gain from taxation. Sec, 1202(b) provides that the maximum gain subject to the exclusion is the greater of $10 million (on a cumulative basis) or 10 times the shareholder's adjusted basis. While this exclusion sounds very enticing, on closer examination, it is not as valuable as it first appeared in 1993. The diminution of the benefit is caused by two factors--changes in the capital gains rates since the RRA '93 and the alternative minimum tax (AMT).

At the time the RRA '93 was passed, the maximum long-term capital gains rate for individuals was 28%; the AMT was raised by that legislation to its current rate of 26% on the first $175,000 of AMT base and 28% on the excess. Section 311(a) of the Taxpayer Relief Act of 1997 (TRA '97) lowered the maximum long-term capital gains rate to 20% for both regular tax and AMT purposes, but not, according to Sec. 1(h)(4)(C) as amended, for Sec. 1202 stock. Thus, the taxable portion of the Sec. 1202 gain continues to be taxed at 28%. Further, for most stock purchased after 2000 and held for more than five years, the 20% rate drops to 18%; this rate will not apply to gains from Sec. 1202 stock, which will continue to be taxed at 28%. Apparently, Congress believes that QSB shareholders are already deriving significant benefits through the 50% exclusion and do not need a further rate reduction. The IRS Restructuring and Reform Act of 1998 (IRSRRA '98), Section 5001(a)(1), lowered the maximum capital gains rate for midterm gains (gains on capital assets held more than 12 months but not more than 18 months) from 28% to 20%; the 28% rate continues to apply to Sec. 1202 stock. The decreases in the capital gains rates on other, less risky investments has reduced the Sec. 1202 advantage, as is later shown.

The AMT Explosion

A further erosion of the Sec. 1202 benefit is caused by the AMT. RRA '93 Section 13113(e) made 50% of the QSB exclusion an AMT preference. Under TRA '97 Section 311(b)(2)(B), the AMT preference was lowered to 42% of the exclusion (i.e., 21% of the total gain). IRSRRA '98 Section 6005(d)(3) lowered the AMT preference to 28% of the exclusion for QSB stock acquired after 2000. As has been widely reported of late, AMT is affecting increasing numbers of individual taxpayers, due in part to the lack of indexing of various AMT factors. A recent Joint Committee on Taxation report(2) indicated that while only 140,000 individual returns reported AMT in 1987, 856,000 will in 1998 and 8,830,000 will by 2008. Further, returns reporting AMT are disproportionately represented in upper-income groups. Of individual taxpayers reporting $200,000 or more, 17.9% are expected to pay AMT in 1998, increasing to 42.7% by 2008. These are the taxpayers most likely to be reporting Sec. 1202 gains. The examples below show that the TRA '97 amendments have essentially eliminated any Sec. 1202 benefit for taxpayers subject to the AMT.

Who Benefits?

Theoretically, Sec. 1202 benefits two groups of taxpayers. First, entrepreneurs--by investing their own funds (as well as sweat equity and brainpower) to develop new products and technologies, entrepreneurs are rewarded by paying lower taxes on the sale of the stock, when the QSB is acquired for megadollars by a large corporation. Second, investors--the upper-income individuals willing to undertake a risky investment; Sec. 1202 is intended to make the risky investment more palatable by reducing the tax bite when the shareholder sells the stock for a profit after the business has become successful. As later shown, this intent is not necessarily achieved.

The Entrepreneur

Questioning the value of Sec. 1202 for the entrepreneur is important in light of the choice-of-entity question faced by many new businesses. Many start-up ventures must decide Whether to operate as a C corporation, with the potential for Sec. 1202 benefits, or as a passthrough entity (e.g., partnership, limited liability company (LLC) or S corporation). Before Sec. 1202's enactment, present value cashflow projections prepared for a new business often favored the passthrough form, because of the tax savings derived from early operating losses and the avoidance of double taxation. Once Sec. 1202 was enacted, the present value of the 50% exclusion at the 28% rate frequently favored the C corporation form. Actual results varied, depending on projections of amounts and timing of profits (losses), distributions and the relative value of the stock. However, the TRA '97 drop in the maximum capital gains rate to 20% for gains on ownership interests in partnerships, LLCs and S corporations erodes the advantage of the 50% exclusion; it may eliminate it if the AMT applies to the QSB stock sale.

Example: B, an entrepreneur, plans to develop a new product, build a business (B Co.) and sell it to a large corporation at the beginning of Year 6 for $1,000,000 in excess of the capital he invested. Because B Co. will be in developmental and growth stages, no distributions will be paid out in Years 1-5. Without distributions, there will be no cashflows to B if B Co. is a C corporation; however, if B Co. is a passthrough entity, B will either pay or save taxes on B Co.'s passed-through income or losses (if B has adequate basis to use losses). B is in the 28% regular tax bracket and has an 8% cost of capital (for present value factors). Table 1 above shows B's cashflows (including taxes paid and (saved)) for five years of operations and the sale at the beginning of Year 6 if B Co. is a QSB or a passthrough entity. B Co. as a passthrough entity is further broken out by the 28% maximum capital gains rate that would have applied under the RRA '93 and the lower rates (20%, 18%) of the TRA '97. Table 2 at right summarizes the present values of the cashflows for each type of entity and capital gains rate.

Table 1: B's cashflows

                                       Tax saved (paid)

                                                 If B Co. is a
Year         Taxable            If B Co.          passthrough
            income/(loss)       is a QSB            entity

1             ($50,000)                0              $14,000
2             ($25,000)                0               $7,000
3                    0                 0                    0
4              $50,000                 0             ($14,000)
5             $100,000                 0             ($28,000)
Sale                          $1,000,000           $1,000,000

                                    Top capital gains rate

                                 28%          20%          18%

No AMT:
Tax on gain      ($140,000)   ($259,000)   ($185,000)   ($166,500)

If AMT on
sale:
RRA '93 (50%
 preference)     ($210,000)   ($259,000)

Current law:
Pre-2001 (42%
 preference)     ($198,800)                ($185,000)
Post-2000 (28%
 preference)     ($179,200)                             ($166,500)
Table 2: Sec. 1202 advantage to B

                       Present values of Table 1 cashflows

                                                       Sec. 1202
                   Sec. 1202 Stock     Passthrough     advantage

No AMT:
RRA '93               $585,299          $493,928        $91,371

Current law:
Pre-2001 stock        $585,299          $544,290        $41,088
Post-2000 stock       $585,299          $556,881        $28,418

If AMT on sale:
RRA '93               $537,658          $493,928        $43,731

Current law:
Pre-2001 stock        $545,281          $544,290           $990
Post-2000 stock       $558,620          $556,881         $1,739

In determining the tax on the gain for B Co. as a passthrough entity, the gain has been adjusted for the prior taxable income and loss built into the basis. The AMT does not affect the tax on the gain for the passthrough entity (other than through the "catch-up" of AMT timing differences), because the same capital gains rate applies for AMT purposes. The tax on the Sec. 1202 stock gain does increase if the AMT applies, because of the additional taxable income created by the preference and taxed at the 28% rate. As Congress has cut capital gain rates, it has decreased the AMT preference, and thus, the AMT, but not to the same extent as the tax cuts on non-Sec. 1202 capital assets.

As can be seen from Table 2 on p. 858, Sec. 1202 provided a significant benefit to B under the RRA '93, when the maximum capital gains rate was 28%. As the maximum capital gains rate on non, Sec. 1202 assets (e.g., interests in B Co. as a passthrough entity) has decreased, the benefit has eroded. If the AMT does not apply to B, the originally intended benefit under the RRA '93 of $91,371 has decreased approximately 55% to $41,088 under the TRA '97 and will decrease a total of 69% (to $28,418) for B Co. stock issued after 2000.

B Co. had a slight advantage as a QSB vs. a passthrough entity under the RRA '93 if the AMT applied; however, the TRA '97 eliminated any significant QSB advantage in such a case. In fact, B now may be worse off. If the Sec. 1202 preference pushes B into the AMT, he permanently loses the benefits of certain deductions and credits (e.g., state and local income and property taxes, childcare credits), sees reduced tax savings on other deductions (e.g., charitable contributions and home mortgage interest) and has to defer the tax savings on certain other credits (e.g., the general business credit). Under current law, it does not appear that a taxpayer can elect out of Sec. 1202 treatment.

This example is extremely simplified, but demonstrates the importance of considering changing tax rates and AMT when choosing the form of entity for a new business.

The Investor

In the investor's eyes, the risk/reward tradeoff of investing in a new venture vs. investing in a safer venture has been altered as the maximum capital gains rate on the latter has declined. The AMT further complicates the investment decision and diminishes the incentives of investing in a new venture. An upper-income individual with other tax-advantaged investments may already be at risk for the AMT; at a minimum, he will already be generating numerous adjustments and preferences from other sources (e.g. various itemized deductions, incentive stock options, depreciation, etc.). As was discussed, it is expected that almost 43% of taxpayers reporting income of $200,000 or more will be paying the AMT in 10 years. The AMT preference of 42% of the Sec. 1202 exclusion (21% of the total stock gain) will increase an already existing AMT problem or cause one if a large gain is generated. Further, the addition to AMT attributable to the Sec. 1202 exclusion is permanent; it does not become part of the minimum tax credit.

Example: J, an upper-income investor, invests $50,000 in stock, holds it for more than five years, then sells it for a $1,000,000 gain. As non-Sec. 1202 long-term capital gain, it would have been taxed at 28% by the RRA '93, 20% by the TRA '97 (18%, if the investment is made after 2000) for both regular tax and AMT purposes. If Sec. 1202 applies, 50% of the gain is excluded; the other 50%, $500,000, is taxed at 28%, plus there is an AMT preference. Under the RRA '93, the AMT preference would have been 50% of the exclusion ($250,000), 42% ($210,000) currently. If the stock is issued after 2000, the preference will be 28% ($140,000). With a preference of this size, it is very likely that AMT will apply. An analysis of the after-tax return on this investment is shown in Table 3 on p. 861.

Table 3: After-tax return on investment

                            Sec. 1202    Sec.1202 inapplicable

                                                     28%
No AMT:
Before-tax profit          $1,000,000          $1,000,000
Regular tax                  -140,000            -280,000

After-tax return             $860,000            $720,000

If AMT on sale:

RRA '93:
Before-tax profit          $1,000,000          $1,000,000
Tax                          -210,000            -280,000

Profit                       $790,000            $720,000

Current law:
Tax--pre-2001 stock          -198,000
Profit--pre-2001 stock       $801,200
Tax--post-2000 stock         -179,200
Profit--post-2000 stock      $820,800

                             Sec.1202 inapplicable

                                20%           18%

No AMT:
Before-tax profit          $1,000,000    $1,000,000
Regular tax                  -200,000      -180,000

After-tax return             $800,000      $820,000

If AMT on sale:

RRA '93:
Before-tax profit          $1,000,000    $1,000,000
Tax

Profit

Current law:
Tax--pre-2001 stock          -200,000
Profit--pre-2001 stock       $800,000
Tax--post-2000 stock                       -180,000
Profit--post-2000 stock                    $820,000

As can be seen, although taxes have decreased since 1993, they have not declined as much for Sec. 1202 investors. Table 4 provides a summary of the comparative after-tax returns on QSB stock vs. other investments, as originally envisioned by Congress and as currently provided.(3)

Table 4: Sec. 1202 advantage to J

                           Summary of after-tax returns

                      Sec. 1202 stock     Other investment

No AMT:
RRA '93                   $860,000            $720,000

Current law:
Pre-2001 stock            $860,000            $800,000
Post-200 stock            $860,000            $820,000

If AMT on sale:
RRA '93                   $790,000            $720,000

Current law:
Pre-2001 stock            $801,200            $800,000
Post-2000 stock           $820,000            $820,000

                   Summary of after-tax returns

                       Sec. 1202 advantage

No AMT:
RRA '93                      $140,000

Current law:
Pre-2001 stock                $60,000
Post-200 stock                $40,000

If AMT on sale:
RRA '93                       $70,000

Current law:
Pre-2001 stock                 $1,200
Post-2000 stock                  $800

If the AMT does not apply, Sec. 1202 provides a savings, but the incentive relative to other investments has decreased by more than 50% since Sec. 1202's enactment. When the 18% maximum capital gains rate becomes applicable, the benefit will be reduced to 29% of the original advantage. If the AMT applies, Sec. 1202 as originally enacted would still have provided a significant advantage relative to more secure investments; the advantage is essentially nil under current law. As was noted above, if the Sec. 1202 preference pushes the taxpayer into the AMT, he is actually worse off by holding QSB stock rather than traditional investments, because of the loss, minimization or deferral of the tax savings from other deductions and credits.

Recent Legislation

Sec. 1045, enacted by TRA '97 Section 313(a), provides some flexibility to investors holding Sec. 1202 stock. Sec. 1045 allows an individual investor who disposes of QSB stock to defer gain recognition by reinvesting the sales proceeds in new QSB stock within 60 days (i.e., a 60-day rollover).(4) The time value of money makes this election valuable for investors in start-ups and makes more funds available for such investments.

The Sec. 1045 election also allows investors to rid themselves of QSB stock before the five-year holding period has elapsed, as long as they have held the stock for more than six months and are willing to invest the proceeds in another QSB. As originally enacted, the rollover was available only for QSB stock held by individuals. IRSRRA '98 Section 6005(f) amended Sec. 1045 to allow rollover treatment for QSB stock held by any taxpayer other than a corporation (e.g., partnerships and S corporations), thus coordinating the provision with the allowable QSB shareholders. The rollover benefit will pass through to individual partners or S shareholders, but not to corporate partners. This correction will make venture capital partnerships much more attractive to individuals seeking to minimize risk by joining a pool of investments, using the resources of professional managers and deferring tax on realized gains.

Potential Capital Gains Legislation

With budget surpluses on the horizon and an unstable investment climate, Congress has proposed lowering capital gains rates even further. If future reductions are not extended to Sec. 1202 stock, the incentive originally intended by the RRA '93 will practically cease to exist. One proposal, the Economic (growth Act of 1998,(5) would cut the capital gains rate to 15% for all capital gains, including Sec. 1202 gains; thus, it would restore some of the benefit that has eroded since the TRA '97. However, the AMT will still be a concern if large gains are realized.

Tax Strategies

Clearly, the best strategy for the entrepreneur choosing a form of business or for the investor choosing an investment is to build the effect of the AMT into the forecasts and test the sensitivity of after-tax returns for likely potential capital gains rate changes. This analysis will make for a more reasoned decision; tax benefits are not always as they appear on the surface, particularly in an ever-changing tax environment.

For an entrepreneur whose business is already structured to qualify as a QSB, but who may then be worse off because of the AMT, the possibility of altering the business to "fail" Sec. 1202 should be considered, perhaps by failing the 80% asset-use test or the 10% investment test. These purposeful failures assume that the business would not be damaged and that the entrepreneur is not accountable to other investors.

When a Sec. 1202 gain is to be realized by a taxpayer and the AMT will significantly reduce the profit from the investment, traditional AMT strategies may be employed, including (1) timing the sale for a year when the additional preference will not cause or increase AMT (perhaps when negative AMT adjustments from other sources will be recognized) or (2) spreading the stock sale over two years so that the AMT computation is not jolted by a big preference in one year. Alternatively, it might be beneficial to alter the timing of deductions that would otherwise be lost (e.g., state and local taxes) or whose benefit will be realized at a lower AMT rate (e.g., charitable contributions).

The Sec. 1045 rollover also provides the opportunity to defer taxes; the tax deferred dollars continue to work for the taxpayer and may be used to pay the tax in a year with a better tax profile, whether through a change in the taxpayer's situation or through legislation. This deferral strategy may be more acceptable to an investor than to an entrepreneur.

Treatment of Losses

Unfortunately, large gains are not always possible with new ventures; losses are a more realistic possibility. In such cases, Sec. 1244 allows ordinary loss treatment for original investors in small start-up corporations. While the criteria for Sees. 1202 and 1244 are not identical, some QSBs will qualify under Sec. 1244; up to $100,000 ($50,000 if single) of a shareholder's loss per year could be deducted at ordinary income rates.

Conclusion

The RRA '93 attempted to make it easier for small, emerging-growth companies to raise capital by enacting Sec. 1202. The tax savings originally envisioned have been evaporating as capital gains rates on other types of investments have been lowered and the effects of the AMT are being felt by increasing numbers of taxpayers. In examining the form of entity to be selected by an entrepreneur and in making choices among investment alternatives by investors, these issues must be taken into consideration.

(1) For a more complete discussion of the requirements, see Bongorno and Burdette, "Tax Clinic: Walking the Sec. 1202 Minefield," 28 The Tax Adviser 483 (August 1997).

(2) Joint Committee on Taxation, Present Law and Issues Relating to the Individual Alternative Minimum Tax (JCX-3-38, 2/2/98).

(3) The calculations in Tables 1-4 are available via spreadsheet from the author at [e-mail].

(4) See Rev. Proc. 98-48, IRB 1998-38, 7, for details on making the rollover election.

(5) HR 4125 (introduced in the House on 6/24/98).

RELATED ARTICLE: EXECUTIVE SUMMARY

* Theoretically, Sec. 1202 benefits two groups of taxpayers--entrepreneurs and investors.

* TRA '97 amendments have essentially eliminated any Sec. 1202 benefit for taxpayers subject to the AMT.

* By 2008, almost 43% of taxpayers reporting income of $200,000 or more will be paying AMT.

For more information about this article, contact Professor Cohen at [e-mail]

RELATED ARTICLE: Abbreviations Commonly Used in The Tax Adviser

ITA            The Tax Adviser
aff'g          affirming
AFTR2d         American Federal Tax Reports, second series (RIA
Ann.           IRS Announcement
CB             Cumulative Bulletin
Cir.           Court of Appeals
Cl. Ct.        Claims Court
COBRA          Consolidated Omnibus Budget
               Reconciliation Act of 1985
Ct.Fed.Cls.    Court of Federal Claims
DC             District Court
ERISA          Employee Retirement Income
               Security Act of 1974
ERTA           Economic Recovery Tax Act of 1981
Fed.Cir.       Court of Appeals for the Federal Circuit
Fed.Reg        Federal Register
F2d            Federal Reports, second series
F3d            Federal Reports, third series
F Supp         Federal Supplement
GCM            General Counsel Memorandum
HIPAA          Health Insurance Portability and
               Accountability Act of 1996
H.Rep.         House ways and Means Committee Report
IR             Internal Revenue News Release
IRB            Internal Revenue Bulletin
ISBRA '98      Internal Revenue Service Restructuring
               and Reform Act of 1998
Regs. Sec.     Treasury Regulation
Rev. Proc.     Revenue Procedure
Rev. Rul.      Revenue Ruling
rev'g          reversing
RRA            Revenue Reconciliation Act of 1993
SBJPA          Small Business Job Protection Act of 1996
Sec.           Section (refers to the Internal Revenue Code
               of 1986 unless otherwise indicated)
S. Rep.        Senate Finance Committee Report
Sup. Ct.       Supreme Court
TAM            Technical Advice Memorandum
TBOR2          Taxpayer Bill of Rights 2
TC             Tax Court (regular decision)
TC Memo        Tax Court (memorandum decision)
TD             Treasury Decision
TRA '86        Tax Reform Act of 1986
TRA '97        Taxpayer Relief Act of 1997
USTC           United States Tax Cases (Commerce Clearing House)

Ann Burstein Cohen, MBA, CPA Adjunct Assistant Professor of Accounting State University of New York at Buffalo Buffalo, NY