To encourage investment in some small businesses, investors have an opportunity to collect gains that are free from federal tax. Investors in Qualified Small Business Corporations may qualify for three different gain exclusion tax breaks. However, under current law, you must act before the end of the year to get the best gain exclusion deal. This article briefly explains the rules.
Qualified Small Business Corporations (QSBCs) are a special category of corporation, the stock of which can potentially qualify for three different gain exclusion breaks. The hot news is that QSBC shares issued between now and December 31, 2013 are eligible for a 100%federal gain exclusion break if you hold shares for more than five years before selling.
The Definition of a QSBC
The following requirements must be satisfied for a corporation to be a QSBC.
In addition, to be eligible for the QSBC gain exclusion breaks, the stock must meet requirements set forth in Section 1202 of the Internal Revenue Code.
Here are the basics about tax-favored QSBC stock, which is covered under Internal Revenue Code Section 1202.
General 50% Gain Exclusion Rule
Under the general gain exclusion rule, QSBC shareholders (other than C corporations) are potentially eligible to exclude from taxation up to 50% of their gains on sale of QSBC stock.
Special 75% Gain Exclusion Rule
The American Recovery and Reinvestment Act of 2009 increased the gain exclusion percentage from the longstanding 50% to 75%. However, the 75% exclusion rate only applies to sales of QSBC shares that were issued between February 18, 2009 and September 27, 2010.
Extra-Special 100% Gain Exclusion Rule
Legislation enacted in 2010 and 2013 created an unbeatable 100% gain exclusion deal for sales of QSBC shares issued between September 28, 2010 and December 31, 2013. The 100% gain exclusion translates into a 0% federal income tax rate on gains when QSBC shares are sold down the road.
Holding Period Requirement
The gain exclusion breaks are only allowed for QSBC stock that you've held for more than five years.
• The general 50% gain exclusion is potentially available for QSBC shares issued before February 18, 2009 and QSBC shares issued after December 31, 2013.
• The special 75% gain exclusion deal is potentially available for QSBC shares issued between February 18, 2009 and September 27, 2010. Due to the more-than-five-year holding period requirement, the earliest possible date to cash in on the 75% gain exclusion is February 18, 2014.
• The extra-special 100% gain exclusion is potentially available for QSBC shares issued between September 28, 2010 and December 31, 2013. Due to the more-than-five-year holding period requirement, the earliest possible date to cash in on the 100% gain exclusion is September 28, 2015. For QSBC shares that have not yet been issued, the 100% gain exclusion deal will only be available for sales that occur sometime in 2018 at the earliest.
The gain exclusion percentage is scheduled to drop back to 50% for shares issued after 2013, unless Congress acts to extend it. Therefore, a December 31, 2013 share issuance deadline applies if you want to take advantage of the 100% exclusion deal.
This article covers federal tax law. There may be different rules in the Stae of Michigan. Consult with an EHTC tax adviser about your situation.