Bulletins

Benefits and Rules of Qualified Small Business Corporation (QSBC) Stock

Dear Clients and Friends:

Are you getting ready to form a new business or reorganize an existing business? This letter summarizes the special tax advantages available to shareholders who sell stock in qualified small business corporations (QSBCs). A QSBC is a C corporation that meets certain criteria. The potential tax benefits can represent a significant inducement to invest in your business. Therefore, it is important that you understand these benefits and plan for them to be available when possible.

Special QSBC Tax Benefits

The unique income tax benefits available to sellers of QSBC stock are:

� The ability to exclude up to 100% of the resulting gains from taxation if the stock was acquired between September 28, 2010 and December 31, 2011 (or 75% if acquired between February 18, 2009 and September 27, 2010; 50% if acquired between August 11, 1993 and February 17, 2009, or after December 31, 2011).

� The ability to roll over (defer) gains by reinvesting in newly issued shares of another QSBC.

The gain exclusion and gain rollover is available only for original issue shares received after August 10, 1993 and held for over five years. Shareholders that are themselves C corporations are ineligible. The taxable part of the gain from the sale of QSBC stock is taxed at 28% up to the amount of excluded gain.

Both the corporation and its shareholders must meet a number of restrictions to qualify for these special QSBC tax benefits. Following is an article with a detailed explanation of opportunities to use the benefits of Qualified Small Business Corporation Stock. We would be happy to meet with you to explain these rules and benefits in detail.

Daniel A. Kosmatka Donnelly , CPA, PFS, CFF
Dennis W. Donnelly, CPA, PFS
Michael R. Gohde, CPA, PFS

What is a QSBC?

QSBCs are a special breed of the C corporation species. The difference between QSBCs and garden-variety C corporations is that QSBC stock is potentially eligible for: (1) several different gain exclusion breaks (within limits explained later) and (2) a tax-free gain rollover break. Most importantly, QSBC shares issued between now and year-end are potentially eligible for a 100% gain exclusion break. Wow! That's why QSBCs are a hot topic.

Stock issued by an S corporation does not qualify as QSBC stock [IRC Sec. 1202(c)(1)]. However, an S corporation, partnership, or other pass-through entity can own QSBC stock [IRC Sec. 1202(g)].

Observation: When QSBC status is available for a start-up business, it can be a tax-smart alternative to the conventional wisdom that operating as some type of pass-through entity is almost always the right way to go.

Let's begin our analysis of QSBCs by covering the gain exclusion breaks and the related AMT preferences, which have both been moving targets recently. We will conclude by covering the tax-free gain rollover privilege and specifics about what it takes to be a QSBC. Here goes.Let's begin our analysis of QSBCs by covering the gain exclusion breaks and the related AMT preferences, which have both been moving targets recently. We will conclude by covering the tax-free gain rollover privilege and specifics about what it takes to be a QSBC. Here goes.

QSBC Gain Exclusion Breaks

General 50% Gain Exclusion Break. General 50% Gain Exclusion Break. Under the general rule, when a C corporation meets the definition of a QSBC, its shareholders (other than C corporation shareholders) are potentially eligible to exclude from federal income taxation up to 50% of the gains (within limits explained later) from selling their shares. [See IRC Sec. 1202(a)(1).]

Enhanced 75% Gain Exclusion Break. The American Recovery and Reinvestment Act of 2009 (better known as the Stimulus Act) increased the QSBC gain exclusion percentage to 75% (within limits explained later) .However, this beneficial change only applies to QSBC shares that were issued between 2/18/09and 9/27/10. [See IRC Sec. 1202(aX3).]

Super-enhanced 100% Gain Exclusion Break. Changes included in the Small Business Jobs Act of 2010 and the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 created a 100% gain exclusion break (within limits explained later) for QSBC shares issued between 9/28/10 and 12/31/11. [See IRC Sec. 1202(a)(4).] In addition, excluded gains from selling such shares do not count as an AMT preference item [IRC Sec. 1202(a)(4)(C)]. That means the advertised 100% gain exclusion deal is actually for real. Imagine that!

Gain Exclusion Summary. As you can see, this is already getting confusing. Here's the summary so far.

� The standard 50% gain exclusion is potentially available for QSBC shares issued before 2/18/09 or after 12/31/11.

� The enhanced 75% gain exclusion is potentially available for QSBC shares issued between 2/18/09 and 9/27/10.

� The super-enhanced 100% gain exclusion is potentially available for QSBC shares issued between 9/28/10 and 12/31/11.

� The gain exclusion will drop back to only 50% for shares issued after this year. Therefore, a 12/31/11 share issuance deadline applies if you want to take advantage of the 100%exclusion.

Curb Your Enthusiasm: There's a Lengthy Holding Period Requirement

The gain exclusion breaks are cool, but please don't get too excited. A more-than-five-year holding period rule must be satisfied before any gain exclusion is allowed. [See IRC Sec. 1202(a)(1).]Therefore:

� The 75% gain exclusion will only be available for QSBC stock sales that occur after 2/18/14 at the earliest.

� The 100% gain exclusion will only be available for sales that occur after 9/28/15 at the earliest.

� For QSBC shares that have not yet been issued, the 100% gain exclusion will only be available for sales that occur sometime in 2016 at the earliest.

Tax Rates on Taxable Portions of QSBC Stock Gains

Unfortunately, the Bush-era capital gains tax rate cuts were not extended to the taxable portion of eligible gains from sales of QSBC stock. Eligible gains are gains for which the applicable exclusion percentage (50%, 75% or100%) is available. We will define eligible gains a bit later.

The important thing to understand at this point is that the taxable portion of an eligible gain is subject to a 28% maximum federal income rate. That translates into an effective maximum tax rate on eligible gains of either 14% if the 50% exclusion applies, 7% if the 75% exclusion applies, or 0% if the 100% exclusion applies. Gains in excess of the eligible gain amount are taxed as garden-variety stock gains. Therefore, the standard 15% maximum federal rate applies to excess gains that are recognized through 2012.

AMT Preference for Pre-2013 QSBC Stock Sales

For AMT purposes, 7% of the excluded gain from a pre-2013 QSBC stock sale (which is usually, but not always, 50% of the total gain) counts a preference item [IRC Sec. 57(a)(7)]. If exactly 50% of the total gain is excluded (under the eligible gain limitation rules explained later), and the entire amount of the preference (7% of 50%) is taxed at the maximum 28% AMT rate, the maximum effective federal income tax rate on the total gain is 14.98% [(28% x 50%) + (7% x 50% x 28%)]. That's a meaningless difference from the 15% maximum rate that applies to long-term gains from garden-variety stock sales through 2012. For taxpayers who are not subject to the AMT, the 14% maximum effective rate on QSBC stock gains (28% x 50%) is better than the standard 15% maximum rate, but not by much.

Bottom Line: For pre-2013 sales, the QSBC stock gain exclusion is basically false advertising.

AMT Preference for Post-2012 QSBC Stock Sales

General Rule. As things now stand, the AMT preference for excluded QSBC stock gains is scheduled to increase from the current 7% to 28% for gains recognized after2012[IRC Sec. 57(a)(7)].

Important Exception. As mentioned earlier, there's an exception to the preceding general AMT preference rule for excluded gains from QSBC shares that are issued between 9/28/10 and 12/31/11 [IRC Sec. 1202(a)(4)(C)]. In other words, the exception applies to shares that are also eligible for the 100% gain exclusion break. Thanks to the exception, the advertised 100% gain exclusion is totally legit: there's is no regular federal income tax hit, and there's no AMT hit either. So, we are talking about an honest-to-gosh 0% maximum federal income tax rate. Wow! Remember: A 0% rate is potentially available only for QSBC shares issued by 12/31/11. The 0% rate is obviously a whole lot better than the 18% maximum rate that is scheduled to apply to post-2012 gains from garden-variety stock that has been held for over five years.

Tax Results under General Rule. If exactly 50%ofthe total gain from apost-2012 QSBC stock sale is excluded, and the entire preference amount (28% of 50%) is taxed at the maximum 28% AMT rate, the effective maximum federal income tax rate on the total gain is 17.92% [(28% x 50%) + (28% x 50% x 28%)].That's a meaningless difference from the 18% maximum rate that is scheduled to apply to post-2012gains from garden-variety stock that has been held for over five years. For taxpayers who are not subject to the AMT, the 14% maximum effective rate on QSBC stock gains (28% * 50% = 14%) is better than the standard 18% maximum rate by a meaningful amount.

If exactly 75% of the total gain from a post-2012 QSBC stock sale is excluded (because the shares were issued between 2/18/09 and 9/27/10), and the entire preference amount (28% of 75%) is taxed at the maximum 28% AMT rate, the effective maximum federal income tax rate on the total gain is 12.88% [(28% x 25%) + (28% x 75% x 28%)]. That's considerably better than the standard 18% maximum rate. For taxpayers who are not subject to the AMT ,the 7% effective maximum rate on QSBC stock gains (28% x 25%) is far better than the standard 18% maximum rate.

Limitations on Excluded Gains

Congress imposed limits on the amount of gain from selling shares in a particular QSBC that can be eligible for the gain exclusion break [IRC Sec. 1202(b)(1)]. We will create our own term of art by calling the amount of gain that qualifies for the applicable gain exclusion percentage (50%, 75%, or 100%) the eligible gain. In any taxable year, a taxpayer's eligible gain is limited to the greater of:

� 10 times the taxpayer's aggregate adjusted basis in the QSBC stock that is sold or

� $10 million reduced by the amount of eligible gain already taken in to account by the taxpayer in prior tax years for dispositions of stock issued by the same QSBC ($5 million if the taxpayer uses married filing separate status). In effect, the$10 million limitation is a lifetime limitation for that QSBC.

Note: The amount of eligible gain that can't be excluded (usually either 50% or 25% of the eligible gain) is the amount subject to the aforementioned 28% maximum federal income tax rate [IRC Sec. l(h)(4)(A)(ii)].

Example 1: $10 million limitation on eligible gain.

Ernst is a married joint filer. His eligible gain when he sells QSBC stock in 2013 is limited by the $10 million rule. Therefore, the maximum gain Ernst can exclude is either: $5 million if the 50% exclusion applies, $7.5 million if the 75% exclusion applies, or $10 million if the 100% exclusion applies.

Warning: Do not forget to take into account the AMT preference (if any) on the excluded gain.

Example 2: 10-times-the-basis limitation on eligible gain.

Fern is an unmarried individual. In 2013, she sells QSBC stock that she has held for over five years with a basis of $2 million for a total gain of $22 million. Fern's eligible gain is limited to the greater of:

� $20 million (10 times the basis of Fern's stock) or

� $10 million reduced by eligible gains taken into account in prior taxable years (if any).

Assuming Fern hasn't previously recognized eligible gains from that QSBC stock, Fern's eligible gain limitation is $20 million, because that is the greater of the two limitation amounts. Therefore, the maximum gain she can exclude is either: $10 million if the 50% exclusion applies, $15 million if the 75% exclusion applies, or $20 million if the 100% exclusion applies.

If the 75% exclusion applies, the first $15 million of Fern's $20 million eligible gain is excluded from taxation. The remaining $5 million of eligible gain (the eligible gain in excess of the excluded amount) is taxed at a maximum 28% rate. The remaining gain of $2 million ($22 million total gain -$20 million eligible gain) is taxed at the prevailing rate for long-term capital gains from stock held for over five years (currently, the scheduled maximum rate for such gains is 18% for post-2012 years).

Warning: Do not forget to take into account the AMT preference on the excluded gain. In this example, the preference is scheduled to be a whopping $4.2 million (28% x $15millionexcludedgain).

Don't Overlook Tax-free Rollover Deal

In addition to the gain exclusion break, there is also a tax-free gain rollover deal for eligible QSBC shares. The rollover deal applies to gains recognized by an individual taxpayer if he or she elects rollover treatment. Under the rollover rule, the gain recognized is limited to the excess of QSBC stock sales proceeds over the amount reinvested to purchase other QSBC shares (replacement stock) during a 60-day period beginning on the date of the original sale. The rolled-over gain reduces the basis of the replacement stock. QSBC stock must have been held for more than six months to take advantage of gain rollover provision. (See IRC Sec. 1045 and Rev. Proc. 98-48.)

If the replacement stock is QSBC stock when it is sold, the applicable gain exclusion is available, as long as the aforementioned more-than-five-year holding period requirement is met. The holding period of the stock sold in the rollover transaction is added to the holding period of the replacement stock(IRC Sec. 1223).

Observation: The rollover provision essentially allows an investor to sell QSBC shares on a tax-deferred basis without losing eligibility for the gain exclusion break when the replacement stock is eventually sold.

Definition of QSBC Stock

Stock will either be QSBC stock in the hands of shareholders or not. QSBCs are treated as regular C corporations for all other legal and federal tax purposes. (Beyond the federal income tax gain exclusion and gain rollover breaks, the standard advantages and disadvantages of C corporation status apply equally to QSBCs.) To be eligible for the QSBC gain exclusion and gain rollover breaks, stock must meet the requirements set forth in IRC Sec. 1202, including the following:

� The stock must be acquired by after 8/10/93, and the taxpayer generally must acquire the stock: (1) upon original issuance (either directly or through an underwriter) or (2) through gift or inheritance.

� The stock must be acquired in exchange for money, other property (not including stock), or services (not including services performed as an underwriter). However, some tax-free transfers and exchanges can also qualify, such as when stock is acquired through gift or inheritance.

� The corporation must be a QSBC at the date of the stock issuance and during substantially all the period the taxpayer holds the stock.

The following requirements must be satisfied in order for a corporation to constitute a QSBC.

� It must be a C corporation. It cannot be: (1) a foreign corporation, (2) a DISC or former DISC, (3) a Section 936 corporation or a corporation with a Section 936 subsidiary, (4) a regulated investment company (RIC), (5) a real estate investment trust (REIT), (6) a real estate mortgage investment conduit (REMIC), or (7) a cooperative.

� The corporation must also satisfy an active business requirement. The requirement is deemed satisfied if at least 80% (by value) of the corporation's assets are used in the active conduct of a qualified business. Qualified businesses do not include the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any other business where the principal asset is the reputation or skill of one or more of its employees; banking, insurance, leasing, financing, investing, or similar activities; farming (including raising or harvesting timber); production or extraction of oil, natural gas, or other natural resources for which percentage depletion deductions are allowed under IRC Sec.613or613A; or the operation of a hotel, motel, restaurant, or similar business.

� The corporation's gross assets cannot exceed $50 million: (1) at all times on or after 8/10/93 and before the stock was issued and (2) immediately after the stock was issued. For this purposes, the value of the corporation's assets is generally based on their adjusted basis in the hands of the corporation. However, contributed property is valued at FMV at the time of its contribution. If after the stock is issued the corporation grows and exceeds the $50 million threshold, it won't lose its QSBC status for that reason.

Conclusion

For the gain exclusion break to be available, the stock must be held for over five years before it is sold. For the tax-free gain rollover break to be available, the stock must be held for over six months. The 100% gain exclusion break will not be available for shares issued after 2011, unless Congress extends the deal. Finally, tax advisors should carefully review IRC Sec. 1202 before concluding that a corporation meets the definition of a QSBC. See Appendix 1 for a sample client letter explaining the benefits of QSBC stock.

We have summarized what we think are the most important eligibility rules here, but there are lots more. For instance, a corporation cannot be a QSBC if it owns too much real estate that is not used for qualified business purposes or if it owns too much portfolio stock or securities.

References:

IRC Sees. 1,57,1045,1202, and 1223.

Rev. Proc. 98-48,1998-2 CB 367.