Paving the Way.

QUALIFYING SMALL BUSINESS STOCK RULES LEAD TO PLANNING OPPORTUNITIES

STOCK AN INCREASING NUMBER of your clients have it, and not too surprisingly they don't want to diminish their gains via taxes. For many, the answer might lay with the complex, yet financially favorable rules for qualifying small business stock (QSBS).

QSBS rules are relevant not just to founders of new businesses, but also to early stage employees, venture capitalists and investors. Many employee stock purchase plan shares, and exercised stock options also qualify under QSBS rules.

HOW IT STARTED

In 1993, the federal government enacted IRC Secs. 1202 and 1045 which provided for very special treatment of certain corporate stock acquired after Aug. 10, 1993. California followed with similar-but not identical-rules to allow for both exclusions and rollovers.

Stock that qualifies under Sec. 1202, when held for at least five years from the date of acquisition, is eligible for a 50 percent exclusion from capital gains taxes up to a cumulative value of $10 million (or, if greater, 10 times the basis of the stock sold). The federally taxed portion is subject to a 28 percent capital gains rate, while an add back under the alternative minimum tax computation, results in a fairly nominal total tax savings on a full $10 million. In contrast, California tax savings are significant. On a full exclusion of $10 million of qualifying gain, the savings can exceed $900,000.

Both IRO Sec. 1045 and California Revenue and Taxation Code Sec. 18038.5 allow for a rollover (deferral of gain) on any QSBS stock that is held for six months or more from the date of acquisition. This provides for the gain's rollover if new QSBS is acquired within 60 days after the sale of the original stock. The advantage of the rollover provisions, particularly when the underlying qualifying stock is highly volatile, cannot be over emphasized. Rather than risking even a one-year hold to qualify for long-term gain treatment, the stock can be held for as little as six months, and the proceeds reinvested in new qualifying stock within 60 days, with no immediate tax paid on the transaction.

For a summary of highlights of the major provisions under IRC Secs. 1202 and 1045 as well as R&TC Secs. 18038.4, 18038.5, 18151, 18152, 18152.5 and 18155.5, see sidebar, Page 23.

ELECTIONS AND REPORTING REQUIREMENTS

The election to roll over under IRC Sec. 1045 and R&TC Sec. 18038.5 may be made on either a timely filed original return or on an amendment of an open year. The election is made on Schedule D, with the gain on sale reported on one line, followed immediately with a line reporting IRC Sec. 1045 (and R&TC Sec. 18038.5) rollover, and the amount of the deferred gain shown as a negative number.

The exclusion of gain under IRC Sec. 1202 (and R&TC Sec. 18038.5) is also made on Schedule D. The gain on the sale is reported, followed immediately with a line showing the excluded amount as a negative number, and the description "Sec. 1202 gain excluded." Since the taxable portion is taxed, for federal purposes, at 28 percent, the net taxable gain should be included in Column (g).

The portion of the gain excluded under Sec. 1202 from capital gains taxation must be included on federal Form 6251, Line 14m, and on California Schedule P, Line 131.

PLANNING OPPORTUNITIES

For clients who invest either as founders, employees or investors in start-up or early stage companies, there are a number of significant tax planning and savings opportunities. Additional services you can offer clients include the generation and maintenance of QSBS basis schedules and tracking of IRC Sec. 1045 (and R&TC Secs. 18038.5 and 18036.5) stock rollover information.

A tax-savings opportunity of particular interest relates to previously filed tax returns. Due to the tax deferred rollover provisions of IRC Sec. 1045 (and R&TC Secs. 18038.4 and 18038.5), a review of a client's open tax years may be beneficial, if the client has been selling; IRC Sec. 1202 qualifying stock and, within 60 days of the sale, investing in other qualifying small business stock. Filing amended returns to roll over gains previously taxed, can produce significant tax benefit for your client.

On a going-forward basis, clients who have met the five year QSBS holding period should consider whether to elect, to exclude or roll over the capital gains generated on the sale. To make an appropriate determination, taxes should be computed both ways. Additionally, for purposes of IRC Sec. 1045, stock acquired under this provision also must be held for at least six months. You must complete an analysis of the timing of stock purchases and sales to ensure that all requirements are met.

To accomplish the client's QSBS calculation and tracking, we suggest using a spreadsheet that lists the qualifying stock sales and cross references qualifying purchases. By documenting the information in this way, it becomes easy to see which purchases occurred within 60 days of a qualifying sale, and what gain may be deferred. This same schedule forms the basis from which to track the carryover information on the "new" Sec. 1202 stock that results from the Sec. 1045 rollover. A separate schedule is necessary for California purposes if any of the sales or purchases are not California qualifying.

Generating and maintaining these schedules will increase the planning and preparation time devoted to serving the client. Since the client's tax savings can be very significant, the extra time and effort are well justified.

INCREASE AWARENESS

Due to the QSBS rules' complexity and relative obscurity, it is possible that neither you nor your client will be aware of the qualifying stock they hold. Although technically you may not be responsible for making your client aware of QSBS status (since you are not necessarily aware of stock that is owned and unsold), failing to do so may create a problem in your client relationship.

We suggest two ways to help IRC Secs. 1202 and 1045-related issues result in positive client interactions. First, send a letter that summarizes the laws and emphasizes the planning opportunities to all appropriate clients. Second, specifically identify in your engagement letter that without direct client information, you cannot know of the status of any stock sale, the stock's possible Sec. 1202 characteristics, nor any potentially qualifying "new" stock that would be eligible for Sec. 1045 rollover.

One of the major implementation difficulties with QSBS rules is the lack of information publicly available about any particular stock's status. For example, if your client acquired stock by exercising stock options, or even employee stock purchase plans, it is possible that over a period of years, some of the stock will qualify and some will not. Suppose the client was hired at a time when the company was Sec. 1202 qualifying. Further suppose that the employee acquired stock (exercised options or directly purchased) before, and after, the Sec. 1202 qualifying period. In this case, the early stock will be eligible for Secs. 1202 and 1045 treatment, and the later stock will not.

To find out if a stock is qualifying or not, your client, or you (acting at your client's request) may need to speak with management about the qualifying status. If the company carefully complied with California statutes, they will have filed a Form 3565 with the corporate return for all California small business stock issued. In our experience, this filing is often missed, and you will have to ferret out, by direct inquiry and possible analysis of financial data, the exact date on which the company stock ceased to qualify under IRC Sec. 1202.

Once you resolve the qualifying issue, you can begin tax planning. Your client will need to weigh all of the possible risks of holding early stage, qualifying stock for the five years necessary to attain an exclusion vs. the potential tax savings. You will be able to assist with quantifying potential savings by using the client's assumptions about stock price and other income and expense items. As this is a labor-intensive process, it is clearly most applicable when large holdings with substantial gains are at issue.

Keep in mind that all possible IRO Sec. 1202 analysis for stock acquired through incentive stock options must also consider the benefits of selling aged (stock held at least two years from date of grant and one year from date of exercise) ISO's as early as possible to recover any AMT paid at exercise.

Working proactively with your clients to identify, analyze and track QSBS stock can not only strengthen your relationship, but also have a very positive economic benefit for your client.

Rebecca E. Alger, CPA and Lisa Jolicoeur CPA, JD, MS are members of the tax group in the Menlo Park office of BDO Seidman, LLP, specializing in personal income tax issues.

FEDERAL SUMMARY

Issuing-Corporation Requirements

* To be eligible as Sec. 1202 stock, the stock must be for a corporation in which the total capitalization prior (and immediately subsequent) to the stock issuance must be under $50 million.

* Specific time limitations exist when there have been taxpayer stock redemptions by the issuing corporation as well as when the issuing corporation has made substantial redemptions of its own stock.

* The corporation must be a domestic C corporation, and must agree to submit reports to the secretary and shareholders, as the secretary may require, to carry out the purposes of this section.

* The corporation must meet certain gross asset tests that include aggregation rules for parent and subsidiary controlled groups so that the entire group may not exceed total capitalization of $50 million.

* The active business requirement states that at least 80 percent (by value) of the corporation's assets are used in the active conduct of one or more qualified trade or businesses. Most startup companies qualify under these definitions.

* Typical service entities such as accounting, engineering, law, financial services, broker services and financial institutions, as well as farming entities and those that provide motel, hotel or restaurant services are not considered "active businesses" that would qualify under Sec. 1202.

* Corporations which have been DISC or regulated investment companies, real estate investment trusts and other such entities also do not qualify under Sec. 1202.

* The corporation may not hold more than 10 percent of the value of its assets (net assets in excess of liabilities) in stock or securities of other corporations that are not subsidiaries.

* No more than 10 percent of the total value of the corporation's assets may consist of real property that is not used in the active conduct of the trade or business.

Taxpayer Requirements

* To qualify as small business stock under the federal provisions, the taxpayer must have acquired stock directly from the issuing corporation. An exception is if a taxpayer received qualifying Sec. 1202 stock as a gift or bequest from the original acquiring taxpayer, or through a partnership distribution.

* If stock in any corporation is acquired solely through the conversion of stock which qualifies under Sec. 1202, then that newly acquired stock is treated as Sec. 1202 stock and the holding period of the stock begins with the original Sec. 1202 stock acquisition.

* A taxpayer may exclude any gain on Sec. 1202 stock, "passed through" any partnership, S corporation, regulated investment company or any common trust fund, in the same manner as if the taxpayer had directly held the stock. This assumes the partner's continuous participation, see Sec. 1202 (g).

* Any Sec. 1202 qualifying stock distributed to a partner from a partnership is treated by the partner as though owned directly.

* Certain provisions exist to prevent loss protection with the use of short sales during the five-year holding period.

FEDERAL ROLLOVERS

UNDER IRC SEC. 1045

Taxpayer Requirements

* Stock meeting Sec. 1202 qualifications, if held for at least six months, is eligible for rollover.

* Any gain on such stock may be deferred by acquiring new Sec. 1202 qualifying stock within 60 days after the sale date.

* Individuals and pass-through entities may roll over gains, but C corporations may not.

* The new stock must meet all of the Sec. 1202 requirements.

* Gain must be recognized to the extent that the cost of the new Sec. 1202 stock is less than the amount realized on the sale of the "old" Sec. 1202 stock.

* The new stock's holding period includes the old stock's holding period, except for purposes of the six-month holding period for rollover.

* The replacement stock must continue to meet the active business test under Sec. 1202 for at least six months after the stock is acquired.

CALIFORNIA SUMMARY

Issuing-Corporation Requirements

* In addition to most of the IRC Sec. 1202 provisions:

1) At least 80 percent of the corporation's payroll, as measured by total dollar value, must be attributed to employment within California.

2) At least 80 percent (by value) of the corporation's assets must be used by the corporation in the active conduct of one or more qualified trades or businesses in California.

* The corporation should file a Form 3565 small business stock questionnaire for any year in which it issues qualifying stock, and a copy should be given to the shareholders who acquire the stock. If the corporation fails to file the form, the burden of providing the qualifications falls on the shareholder.

Taxpayer Requirements

* Similar to all federal provisions, modified by the California payroll and asset requirements identified above.

CALIFORNIA ROLLOVERS

UNDER SEC. 18038.5

Taxpayer Requirements

* This provision is contained solely in the personal income tax section. Thus, it's unclear if the election to roll over QSBS gains may be made for partnerships or LLCs.

* Except for requiring the newly acquired stock to qualify under California rules, the rollover provisions for individuals are almost identical to the federal rules.

Did You Know...

That stock meeting IRC Sec. 1202 qualifications, If held for at least six months, is eligible for rollover?