Small Business Stock Sales and Exchanges
Corporate stock is considered an investment, in which the shareholder is distinct from the business. Thus, ownership of the shares is considered a capital asset, even if the equity interest is in noncapital business assets. Gain or loss from the exchange of stock is a capital gain or loss, which, if held long-term, will be taxed at lower rates. Small business stock that satisfies certain tax rules enjoy significantly greater tax advantages over any other type of investment. Up to $10 million of capital gains from stock sales can be excluded from income. This Qualified Small Business Stock, or QSBS, exemption has become a tremendous boon to some wealthy investors.
Stock sales by individuals are given preferential tax treatment. If a capital gain is a long-term capital gain, meaning that the asset has been held longer than 1 year, then the tax rate will be 0%, 15%, or 20%, depending on the taxpayer's income; otherwise it is considered ordinary income, subject to the marginal tax rate of the shareholder. There may be other tax advantages for small business stock if they qualify under IRC §1244 or §1202. However, a corporation does not gain preferential treatment from the sale of a capital asset, since a capital gain is taxed as ordinary income. Furthermore, a corporation can only deduct capital losses from capital gains.
Public stock is a highly liquid asset that can easily be converted into cash, but stock in a private corporation is much less liquid, since there is no public disclosure of the sale price. Instead, the seller and buyer negotiate privately to arrive at a mutually agreed upon price. However, the stock of closely held corporations cannot simply be sold to anyone if the stockholders are subject to buy-sell agreements, which often stipulate that the stock 1st be offered to other shareholders or to the corporation, or the sale must be approved by the Board of Directors before they can be sold to a 3rd party. S corporations, in particular, must restrict the sale of stock, since only United States citizens or residents can own stock in an S corporation. Since there is no public bidding on small business stock that would set its value, to minimize shareholder disputes and to avoid expensive professional appraisal or litigation, buy-sell agreements are often subject to a formula to determine the price of the stock, such as discounted cash flow or the capitalization of earnings.
The gain or loss of a stock sale = the sale price, or equivalent value, minus the stockholder's tax basis in the stock, = to the purchase price of the stock + commissions on the transaction or to the substituted basis of property if the stock was acquired in a nontaxable §351 exchange. If the stock was acquired at different times and at different prices, then the owner must keep track of stock purchase dates and prices. Subsequent contributions of capital by the shareholder or a return of capital from the corporation to the shareholder changes the basis of the stock — contributions increase the stock basis, while a return of paid-in capital decreases it.
When stock is sold, the shareholder can decide which lots of stock were sold; if the shareholder cannot determine when the stocks were purchased or the purchase price, then the tax code stipulates that the basis of the earliest acquired stock must be used.
Private stock finances many small businesses, which helps to create jobs and its concomitant tax revenue, so Congress added some sections to the Internal Revenue Code, specifically IRC §1244 and IRC §1202, to promote the sale of what is called small business stock, by giving certain tax advantages to their sale, thereby promoting the growth of the economy, which is largely effected through the creation of small businesses. Consistent with these objectives, these tax advantages only apply to active businesses, not businesses created largely for managing investments or businesses that provide the services of its employee-owners, such as personal service corporations. The corporation must also directly benefit from the initial stock sale, so stock qualified for these tax advantages must be bought directly from the corporation, not from another stockholder. However, people who receive stock as a gift will also directly benefit from these tax advantages.
Section 1244 Stock
A C corporation can issue a certain type of stock, called §1244 stock, which receives preferential tax treatment if the shareholder suffers losses on the stock. IRC §1244 allows stockholders of qualified stock to treat losses from the sale of the stock as a net operating loss from a trade or business and, thus, deductible from other forms of income. If the business fails or if the shareholder sells the stock at a loss, then up to $100,000 ($50,000 if married filing separately) of the loss can be deducted against other ordinary income in the 1st year of the loss. The $100,000 limit applies even if only 1 spouse owns the stock. Any losses over $100,000 are considered capital losses and can be carried forward but only $3000 per year can be used to offset ordinary income — remaining losses must be carried forward. However, any amount of §1244 losses can be used to offset capital gains. To claim a loss under §1244, the taxpayer must file a statement with his individual tax return to explain the loss. The loss is claimed on Form 4797, Sales of Business Property.
Example: How to Deduct Losses on §1244 Stock
- You invest $142,000 in a small business corporation that qualifies as a §1244 corporation in exchange for §1244 stock.
- The corporation subsequently goes bankrupt, with no distributable assets for its equity holders.
- Therefore you have lost all $142,000 of your investment.
- However, since you make $250,000 annually as a neurosurgeon, you can deduct $100,000 of your loss against your working income.
- The remaining $42,000 can be deducted in future years.
- If you have no capital gains in future years, then you can only deduct $3,000 per year for the next 14 years.
To receive Section 1244 treatment, the following requirements must be satisfied:
- the stock must have been issued after November 6, 1978 in exchange for money or property — not services or other stock or securities — to an individual taxpayer or a partnership in which the taxpayer was a partner at the time the exchange;
- investors can only be individuals, not other types of business entities, such partnerships or other corporations, nor can it be a trust, even a revocable trust;
- the corporation must have received more than 50% of its gross receipts from an active business in the 5 tax years prior to the year of the sale, so income from royalties, rents, interest, dividends, annuities, and security sales must be less than 50% of the corporation's income.
- corporation losses must be from active business operations, not investments;
- the total money or property exchanged for §1244 stock cannot exceed $1 million — property is valued at its adjusted basis;
- the corporation must be domestic; and
- the shareholder must be the original purchaser of the stock.
Additional rules apply to stock that was issued after June 30, 1958 but before November 7, 1978.
Section 1244 does not apply to any contributions made after the initial shares are issued. However, later contributions can qualify if the investor receives shares that were authorized but not issued. The §1244 stock should be issued pursuant to a written corporate resolution. A loss can be claimed by individual shareholders as a §1244 stock loss on Form 4797, Sales of Business Property and must be filed with the shareholder's individual income tax return.
A §1244 loss can also be claimed on worthless securities; however, determining when the securities became worthless can be problematic. A company declaring bankruptcy or becoming insolvent is a good sign that its securities are worthless. However, in some instances, they may have some value if the company is reorganizing. Since it is sometimes difficult to determine exactly when a security becomes worthless, the tax code allows the recognition of loss for worthless securities on an amended return for up to 7 years after the due date of the year in which the securities became worthless. The loss can also be recognized if the stock owner relinquishes all ownership rights to the stock, effectively abandoning it.
Section 1202 Qualified Small Business Stock
A non-corporate taxpayer who has held small business stock that qualifies under IRC §1202 for more than 5 years can exclude at least 50% of any gain from the disposition of the stock. More can be excluded if the stock was issued by a corporation in an Empowerment Zone or if it was issued within certain dates.
|Qualified Small Business Stock||50%|
|Issued by Corporation in Empowerment Zone||60%|
|Issued February 18, 2009 – September 27, 2010||75%|
|Issued after September 28, 2010||100%|
However, except as noted in the table, 7% of the excluded gain is an AMT tax preference item includable in the seller's alternative minimum taxable income.
Qualified small business stock must also have been issued after August 10, 1993 by a C corporation and acquired by the taxpayer as an original issue in exchange for money, property, or, unlike for §1244 stock, for services provided to the corporation. Stock that has been acquired because of a conversion from preferred stock or by the exercise of options or warrants is deemed to have been acquired as original issue. However, qualified small business stock cannot be acquired from another stockholder, since the corporation must be the seller.
Except for a regulated investment company, the issuing corporation must be a domestic C corporation, or a cooperative or other similar pass-through corporation, with aggregate gross assets that does not exceed $50,000,000 at the time of the stock's issuance. Members of a controlled corporate group are considered 1 corporation when applying the $50,000,000 asset test. Furthermore, during the taxpayer's holding period, at least 80% of the corporation's assets must have been used in an active qualified trade or business (active business test), which does not include the performance of services in such fields as health, law, engineering, architecture, hospitality, farming, insurance, finance, mineral extraction, or any industry that primarily provides a service. The main industries that benefit include manufacturing, technology, and retail and wholesale.
Qualified small business stock can also be rolled over if it was held for longer than 6 months and replaced with the purchase of other qualified small business stock within 60 days of the sale — called a §1045 rollover. The replacement stock must meet the active business requirement for at least 6 months after the purchase. The holding period will be added onto the holding period of the previous stock and any gain realized on the purchase of the replacement stock reduces the taxpayer's basis in the stock. Special rules apply to partnerships and limited liability companies.
Section 1202 gain exclusion is limited to the greater of:
- $10,000,000 less any eligible gains recognized in prior years or
- 10 times the basis of the corporation's qualified small business stock disposed of by the individual during the year.
This rule applies to any 1 corporation.
Example: Section 1202 Exclusion
Assume that you have 40,000 shares of small business stock that qualifies under §1202, and that you sell some of the stock in 2008 and the remaining shares in 2020. Using the given facts provided by the table below, you calculate your exclusion amounts thus:
|Number of Shares||40,000|
|Purchase price per share |
|2008 Stock Sale|
|Number of shares sold in 2008||12,000||Note that the taxpayer has held the stock for more than 5 years.|
|2008 Sale Price per Share||$400|
|2008 Gain = |
Sale Price − Purchase Price =
|$10,000,000 Limitation||$10,000,000||= $10,000,000 − Eligible Gain in Prior Years|
|10 × Basis of Stock disposed during the year||$7,200,000||= 10 × Number of Shares Sold × Stock Basis |
= 10 × 12,000 × $60
|Applicable Amount Eligible for Section 1202 Exclusion =||$4,080,000||= Entire Amount since it is less than the Greater of ($10,000,000 Limitation or 10 × Basis of Stock Disposed during the Year)|
|2008 Excludable Amount = Gain × 50% =||$2,040,000|
|2015 Stock Sale|
|Number of shares sold in 2020||28,000|
|Sale Price per Share||$700|
|Gain||$17,920,000||= Sales Proceeds − Stock Basis |
= 28,000 × $700 − 28,000 × $60
|$10,000,000 Limitation||$5,920,000||= $10,000,000 − Eligible Gain in Prior Years |
= $10,000,000 − $4,080,000
|10 × Basis of Stock disposed during the year||$16,800,000||= 10 × Number of Shares Sold × Stock Basis |
= 10 × 28,000 × $60
|Applicable Amount Eligible for Section 1202 Exclusion =||$16,800,000||= Greater of ($10,000,000 Limitation or 10 × Basis of Stock Disposed during the Year)|
|Section 1202 Exclusion = Eligible Amount × 50% =||$8,400,000|
S corporation stock is not eligible for §1202 exclusion since it only applies to C corporations. However, S corporation stock can qualify as §1244 stock. When an S corporation shareholder sells the shares, the stock basis must be adjusted by the allocations of income and losses and distributions from the corporation up to the date of the sale.
Deferred Gain Recognition by Investing in a Specialized Small Business Investment Company
Up to $50,000 ($25,000 if married filing separately) of gains from the sale of publicly traded securities can be deferred annually by reinvesting the proceeds, within 60 days, in either stock or a partnership interest of a specialized small business investment company (SSBIC). The gain is deferred by reducing the basis in the stock or the partnership interest by the amount of the deferral, so the gain is recognized when the SSBIC interest is sold. However, there is a $500,000 lifetime limit ($250,000 if married filing separately) on the deferrals.
An SSBIC is a partnership or corporation licensed by the Small Business Administration under §301(d) of the Small Business Investment Act of 1958 to provide venture capital to small businesses owned by minorities who are deemed socially or economically disadvantaged. The capital is provided as either straight debt financing or as equity participation loans to either provide startup funding or help a small business grow. The SSBIC uses its own private source of funds plus borrowed money guaranteed by the Small Business Administration. IRC §1044
How the Wealthy Get Even More Tax Savings from Qualified Small Business Stock (QSBS)
The tax-free treatment of small business stock sales is a boon to the wealthy, especially to venture capitalists, and they have used additional methods to increase their tax-free income. One method is known as stacking, where the buyers of the QSBS give much of it to family and friends, where each recipient can enjoy the same tax advantages as if they bought the stock themselves. Indeed, another common method is to give the stock to separate trusts that benefit the same recipients, such as the children of the investor.
Another strategy is called packing, where a company that has grown in value could be merged with a QSBS company, thereby increasing the basis of the QSBS company, which means that up to 10 times the new basis could be excluded from taxation. So, if you had invested $1 million in a QSBS company, then merged another company you owned that had increased in value to $7 million, then your qualifying basis for the QSBS would be $8 million, which could exempt up to $80 million of income from taxes!