Qualified Small Business Stock Requirements
To qualify for the 100% exclusion (in addition to completing the acquisition after September 27, 2010 and before January 1, 2014), all of the other requirements applicable to investments in qualified small businesses must be met, including, among other things:
- 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 original issuance of the stock must be acquired from the corporation (directly or through an underwriter);
- The corporation must meet certain “active business” requirements, meaning generally that it must use 80% 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; and
- 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.The Act also provides, on a retroactive basis, that for purposes of determining the eligibility for the 100% exclusion, the acquisition date for stock is the date on which the investor’s holding period for the stock begins. While committee reports are not yet available, a summary issued by the Senate Finance Committee described this provision as a clarifying provision. However, this rule appears to constitute a significant change in the law that limits the benefit of the exclusion, and it may also have some potentially unintended consequences. For example, if, during the qualifying period, a stockholder contributed property (or converted a note) that was acquired prior to September 27, 2010 to a corporation in a tax-free exchange for stock, the 100% exclusion apparently would not apply to the stock. However, prior to the changes under the Act, the statute was clear that such an exchange would have been eligible for the 100% exclusion. Notably, in what appears to be an unintended consequence, the foregoing provision of the Act could also be read to allow an investor whose holding period begins after September 27, 2010 (for example, as a result of the receipt of stock in 2013 in exchange for property acquired during 2011) to apply his or her “tacked-on” holding period for purposes of the general five-year holding period requirement. As a result, the stockholder may not need to actually hold the stock for the entire five-year period.
Because the Act retroactively extends the window during which qualifying investments can be made, investors who acquired stock during 2012 should consider whether the stock qualifies for the 100% exclusion. Also, investors who, after September 27, 2010, acquired stock in nontaxable exchanges of assets (such as LLC interests or notes) that were acquired before September 27, 2010, will need to determine whether the new holding period requirements of the Act retroactively preclude them from qualifying for the 100% exclusion.
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 a corporation to a domestic C corporation would generally not enable the current stockholders to qualify for the 100% exclusion with respect to any stock that they currently hold. In addition, the new rule for determining the acquisition date for stock could limit the application of the 100% exclusion to stockholders who receive their stock in exchange for property that was held by the stockholder prior to September 27, 2010.
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 its shares from qualifying for the exclusion.
© 2013 Perkins Coie LLP