Qualified Small Business Stock & 1244 Stock
By Peter Jason Riley
A taxpayer may be allowed to exclude from taxable income a portion of the gain realized on the sale of qualified small business stock. There are two sections of the Internal Revenue Code that provide such an opportunity. Section 1202 permits a taxpayer to exclude a specified percentage of such gain, while §1045 permits a taxpayer to avoid, or at least defer, recognition of potentially all such gain if the taxpayer reinvests in qualified small business stock within sixty days.
Section 1202 permits a taxpayer, other than a corporation, to exclude in general 50% of the gain realized on the sale of such stock if the taxpayer holds the stock for more than five years prior to sale. The amount of gain which may be excluded in this manner is limited, on a "per issuer" basis, to the greater of $10 million or ten times the taxpayer's basis in the stock. A portion of the gain excluded under §1202 must be added back, however, as a preference for alternative minimum tax purposes.
Qualified small business stock means any stock in a domestic corporation that is originally issued after August 10, 1993 if: (1) the corporation is a "qualified small business" upon issuance of the stock; and (2) the stock is acquired by the taxpayer at its original issue in exchange for money, other property (not including stock), or as compensation for services provided to the corporation. To prevent the evasion of the requirement that stock be "newly issued," stock acquired by the taxpayer will not be treated as qualified small business stock if the corporation purchases any such stock from the shareholder or a related person within two years before or after issuance of the shares for which the exclusion is sought. Furthermore, §1202 treatment will not be available to a taxpayer if, within one year before or after issuance, the corporation redeems more than 5% of the aggregate value of all of its stock as of the beginning of such period, although redemptions incident to certain events, such as death, divorce, disability, incompetency, and certain de minimis redemptions are disregarded for these purposes.
A "qualified small business" is a domestic C corporation, the gross assets of which at all times on or after August 10, 1993 through the issuance of the stock in question do not exceed $50 million (without regard to liabilities). The corporation must be an "active business," rather than simply an investment company. A corporation will fail this requirement if more than 10% of the value of its net assets consists of stock and securities of other corporations (not including that of a subsidiary). In addition, a corporation does not meet this requirement if more than 10% of the total value of its assets consists of real property that is not used in the active conduct of a qualified trade or business. For these purposes, the ownership of, dealing in, or rental of real property is not considered the active conduct of a qualified trade or business.
Gain from the disposition of qualified small business stock by a partnership, S corporation, regulated investment company or common trust fund that is taken into account by a partner, shareholder or participant therein is eligible for §1202 exclusion if all of the requirements of a qualified small business and qualified small business stock are met and if the taxpayer held its interest in the entity on the date the stock was acquired and at all times thereafter until the stock's disposition. To avoid the circumvention of the holding period requirements, the amount of gain so excluded cannot exceed the amount determined by reference to the taxpayer's pro-rata interest in the entity upon the acquisition of the stock.
In addition to meeting all the requirements to qualify for the general 50% exclusion, if the stock sold is acquired after December 31, 2000, in a corporation which is a qualified business entity (under empowerment zone rules), a 60% exclusion applies.
Section 1045 permits a taxpayer, other than a corporation, selling "qualified small business stock," after August 5, 1997 to defer gain on such sale by rolling over the gain into a new investment in qualified small business stock. Rollover treatment under §1045 is available if: (1) the taxpayer has held the original stock for more than six months; and (2) the taxpayer makes a special election to claim §1045 treatment on the taxpayer's federal income tax return for the year of sale.
Deferral of gain under §1045 is available only to the extent that the amount realized upon sale does not exceed: (1) the cost of any new qualified small business stock purchased during the 60-day period beginning on the date of such sale; reduced by (2) any portion of such cost already used to shelter gain under §1045.
The application of these rules in any specific instance is complex and requires careful planning. Please contact me at your convenience so that we may discuss how these rules apply to your situation.
Section 1244 of the Internal Revenue Code, the small business stock provision, was enacted to allow shareholders of domestic small business corporations to deduct as ordinary losses, losses sustained when they dispose of their small business stock. In order to receive this beneficial treatment, the Code prescribes specific requirements for: (1) the corporation issuing the small business stock; (2) the stock itself; and (3) the shareholders of the corporation.
(1) The corporation issuing the stock must qualify as a domestic small business corporation, which generally means that it must be created under the laws of the United States and that its aggregate capital must not exceed $1,000,000 at the time the §1244 stock is issued to its shareholders. The first taxable year in which the capital of the corporation exceeds $1,000,000 is called the transitional year, and the corporation must designate which shares issued that year qualify for §1244. For example, if a newly formed corporation received $2,000,000 for its initial issue of stock, it could designate up to $1,000,000 of its stock as qualified §1244 stock.
The corporation must also satisfy a gross receipts test. This test requires that the corporation, during the period of its five most recent years ending before the date the loss on its stock was sustained, derive more than 50% of its gross receipts from sources other than passive investment income. The gross receipts test thereby confines the tax relief provided by the small business stock provision to the stock of corporations actively engaged in a trade or business. The gross receipts test does not apply where, for the entire period for which gross receipts are measured, the gross income of the corporation is less than the business deductions allowed to the corporation by the Code.
The Code also imposes recordkeeping requirements on the corporation relative to its §1244 stock. Among these is requirement that the corporation designate designation, for its transitional year, those of its outstanding shares that qualify for small business stock treatment.
(2) Common stock, and preferred stock issued after July 18, 1984, qualifies as §1244 stock. In order to qualify as §1244 stock, the stock must be issued, and the consideration paid by the shareholder must consist of money or other property, not services. Stock and other securities are not "other property" for this purpose. However, cancellation of indebtedness may be sufficiently valid consideration.
(3) Section 1244 is available only for losses sustained by shareholders who are individuals. Losses sustained on stock held by a corporation, trust or estate do not qualify for §1244 treatment. Subject to very limited exceptions, the benefits of §1244 are only available to individuals who acquire the stock by issuance from a domestic small business corporation, and are not available to a subsequent transferee of the stock. In some cases, a partnership can qualify as a shareholder of §1244 stock. Generally, all transfers of §1244 stock by the shareholder, whether in a taxable or nontaxable transaction, whether by death, gift, sale or exchange, terminate §1244 status.
Once all of the requirements of §1244 stock are met, ordinary loss treatment for losses on a sale or exchange of §1244 stock is permitted if the loss would otherwise be treated as a capital loss. The amount of ordinary loss that an individual taxpayer may realize by reason of the small business stock provision is subject to certain limitations. Any amount of §1244 loss in excess of this limitation is treated as a capital loss. For losses incurred in taxable years beginning after 1978, the maximum amount that a taxpayer may claim as an ordinary loss for all losses sustained on §1244 stock in a taxable year is $50,000, generally, or $100,000 if a joint return is filed.
Because the rules under §1244 are complicated, I encourage you to contact your tax advisor how they apply to your situation.