President Obama signed into law the Protecting Americans from Tax Hikes Act of 2015 (the PATH Act) on December 18, 2015.  Among other provisions, the PATH Act provides that the 100 percent exclusion from gross income of certain capital gains from sales of qualified small business stock will apply to all investments made after September 27, 2010, including investments made in 2015 that were not eligible for the exclusion prior to the passage of the PATH Act.

Qualified Small Business Stock Requirements

To qualify for the 100 percent exclusion all of the requirements applicable to investments in qualified small businesses must be met, including, among other things, each of the following:

• The holding period of the stock must begin after September 27, 2010.
• The stock must be held for more than five years, subject to certain exceptions for qualifying tax-free “rollovers.”
• The exclusion applies only to noncorporate taxpayers.
• The small business must be a domestic C corporation.  An S corporation is ineligible.
• The stock must be acquired at its original issuance from the corporation, directly or through an underwriter.
• The corporation must meet certain “active business” requirements, meaning generally that it must use 80 percent of its assets (by value) in a qualifying active business (excluding certain types of businesses, such as financial institutions, farms, professional service firms, hotels and restaurants and similar businesses) for substantially all of the investor’s holding period.
• The corporation must not have made certain redemptions of its stock prior to or following the acquisition of the stock.
• The aggregate gross assets—defined generally as cash plus the aggregate adjusted tax basis of other property—held by the small business must not exceed $50 million at any time before or immediately following the investment by the investor (including amounts received by the small business from the investor).

In addition, there is a per issuer limit on gains eligible for the exclusion equal to the greater of $10 million or 10 times the adjusted tax basis of stock issued by the corporation.

Does Your Stock Qualify for the 100 Percent Exclusion?

Because the PATH Act retroactively extends the window during which qualifying investments can be made, investors who acquired stock during 2015 should consider whether the stock qualifies for the 100 percent exclusion.

C Corporation Structure.  Companies that are just being formed, or are currently not structured as domestic C corporations (such as limited liability companies), should consider whether being formed as, or converting to, a domestic C corporation could permit equity holders of the company to benefit from the 100% exclusion.  However, with respect to S corporations and other noneligible corporate entities, converting the corporation to a domestic C corporation would generally not enable the current stockholders to qualify for the 100 percent exclusion with respect to any stock that they currently hold.

September 27, 2010 Limitations.  In addition, the rule defining the acquisition date for stock acquired after September 27, 2010 as the first day of the holding period of such stock could limit the availability of the 100 percent exclusion to stockholders who receive their stock in exchange for property that was held by the stockholder prior to September 27, 2010.

Exclusion Eligibility.  Provided all of the requirements are otherwise met, the exclusion may apply to preferred stock investments, the issuance of common stock, including to founders and employees, shares issued upon the conversion of convertible debt and shares issued upon the exercise of stock options.

Otherwise eligible corporations should consult with their advisors prior to redeeming any shares as such redemptions may prevent their shares from qualifying for the exclusion.

© 2015 Perkins Coie LLP