Last time, we wrote about the more popular provisions of Section 1202 and the Qualified Small Business Stock (QSBS) opportunity – excluding up to $10 million from capital gains taxes. It is an enticing enough provision for founders and investors alike. But there are additional provisions that are worth understanding as well.
If you need a quick refresher on the tax treatment/opportunity for founders and investors you can read our last article on Section 1202 here.
The other two less well-known benefits of QSBS are Section 1045 and Section 1244. To be clear, they are less well-known because they are nowhere near as beneficial as Section 1202 benefits but that doesn’t mean they should be ignored. Let’s dive into both and get a better understanding.
Section 1045 – Rollover of Capital Gains from QSBS
Many of you are probably familiar with 1031 or 1035 exchanges. These allow you to defer paying taxes when you sell real estate for ‘like kind’ real estate (1031) or allows you to move money from one insurance/annuity contract to another without paying taxes (1035).
Section 1045 is similar, but it applies to Qualified Small Business Stock (QSBS).
The same guidelines apply for Section 1045 as in Section 1202.
1) The issuing company must be a C Corporation.
2) The stock in the C Corporation must have been issued after August 10, 1993 and the gross value of the assets of the issuing corporation must have been less than $50 million at the time the stock was issued and immediately after.
3) At least 80% of the assets of the corporation have been used in the active conduct of one or more qualified trades or businesses.
4) The stock must have been acquired at ‘original issue’.
Section 1045 – What’s the benefit?
If a company meets the conditions set forth above and you have owned the stock for at least 6 months when you sell your shares in the company you can ‘rollover’ the gain to another qualified small business stock within 60 days.
Pretty simple. Own QSBS for at least 6 months. Sell QSBS and buy new QSBS within 60 days and you don’t have to pay income taxes on ANY of the gain. Of course, the gain and subsequent deferral election must be recorded properly on your tax return.
The initial law as passed referred specifically to taxpayers. However, it was amended one year later to a ‘taxpayer other than a corporation’ – meaning it applies to partnerships, trusts, LLCs, and more. The pass-through nature of Section 1045, therefore, seems to apply directly to angel funds and their members.
Section 1244 – Ordinary Income Loss on QSBS
Not all startups end with a successful exit. As a matter of fact, we know the vast majority of startups exit with a thud rather than a bang. While no one really likes to see an investment lose money there is a provision in the tax code to take a little sting out for investors of unsuccessful enterprises.
IRC Section 1244 is a provision in the tax code allowing stockholders of Qualified Small Businesses to treat part of your loss as an ordinary loss rather than a capital loss! How much? For married filing joint filers, you can claim up to $100,000 and for single filers you can claim up to $50,000!
Capital Gains versus Ordinary Income
Let’s put this in context. Under most instances when you have a loss as a stockholder you are able to claim it as a capital loss. If you own it for less than a year, it is a short-term loss and if you own it for more than a year it is a long-term capital loss.
For simplicity and brevity, I’m assuming everyone understands the rates and the way short-term and long-term positions affect each other.
Regardless, if your capital losses exceed your capital gains, you can use up to $3,000 as a capital loss to offset ordinary income and then carry forward the remainder, if there is any, to the following year. The loss carryforward can then be used to offset capital gains in that year.
So losses, as we’ve known them for some time, allow for up to $3,000 to offset ordinary income.
But IRC Section 1244 allows married filing joint filers to claim up to $100,000 to be used to offset ordinary income (individual and head of household can claim up to $50,000).
Requirements for Section 1244 Treatment
There are obviously necessary requirements for this special treatment.
1) At the time of issuance, the company was a small business corporation. The definition of a small business corporation means its aggregate capital can’t exceed $1,000,000 upon issuance of the stock. In the taxable year when aggregate capital exceeds $1,000,000 the company must designate which shares qualify;
2) Cash or other property was used to acquire the shares in the company; and
3) For the most recent 5 years prior to the loss, the company must have generated at least 50% of its income from sources other than passive investment income (income excluding royalties, rents, dividends, interests, annuities, and sales or exchanges of stocks or securities).
Similarly, to Section 1202 and the capital gains exclusion, you must own actual stock – not a convertible note for this to qualify. Fortunately, preferred stock qualifies for Section 1244 treatment as long as it was issued after January 18, 1984.
Planning Opportunities with 1045
Remember, Section 1202 allows you to realize the gains and not pay capital gains taxes on gains up to $10 million.
And Section 1045 simply allows you to DEFER paying capital gains. In essence, your basis in the first company carries over with you and serves as the cost basis in the shares of the second company.
For example, let’s assume you invest $100,000 into a QSBS in 2012, in 2016 it sold and your share was $1,000,000. If you were able to identify a new QSBS and invest in that company within 60 days of the sale of the previous shares, your basis in Company 2 would still be $100,000, not $1,000,000.
At some point in the future, when you sell the shares in the new company you will have to pay taxes with a basis of $100,000 (though you may still be able to claim an exclusion under Section 1202 as long as the shares are held for at least 5 years).
So why defer when you can claim the gain and not pay?
There doesn’t seem to be any discouragement from combining Section 1202 with Section 1045 – or vice versa.
Huh?
What if you sold your stock in a company and the gain was $15 million? You could exclude up to 100% of the gain (depending on the year the company was founded) of up to $10 million. However, the remainder of the gain ($5 million) would still be taxed. If you properly planned and had another investment opportunity lined up you could invest up to $5 million and still not pay capital gains.
You may also have invested in a company in 2007 when the exclusion was ‘only’ 50% of the gain up to $10 million. As such, you may not want to pay taxes on the other 50%, or some portion of it.
If that’s the case, you could ‘rollover’ the gain from one QSBS to another QSBS and defer the gain. By all measures, it would also allow you to qualify the gain within THIS QSBS.
Considerations for 1045:
1) Let’s assume Peter bought shares of Company X (a QSBS) in 2013 for $100,000. On April 1, 2016 the company sold and Peter’s shares were worth $1,000,000. This is a situation where the gain does NOT qualify for Section 1202 because the stock was not held for 5 years. As such, Peter has a gain of $900,000 – by all indications, the gain will be taxed at 23.9%. If he is able to identify a new QSBS to invest in prior to May 30, 2016, then he can defer all or part of the gain (depending on how much he invests in the new QSBS).
2) Let’s assume Mary bought shares of XYZ Corporation (a QSBS) in 2007 for $50,000. On June 1, 2016 the company is sold and her shares are now worth $750,000. Only 50% of her gain of $700,000 is excludable. If she finds a new QSBS stock to invest in, then she can reduce her capital gain for this year.
However, her cost basis in XYZ Corporation would carry her forward to the new company. If she holds the stock for 5 years though, all indications are that she can exclude 100% of the gain up to $10 million since she acquired the new QSBS in 2016.
Clearly, either one of these Sections of the Internal Revenue Code helps minimize taxes in any given year. However, the combination of the two can be pretty powerful. Unfortunately, taking proceeds from one successful QSBS and moving it directly into another successful QSBS is a lot easier to write about than to execute. If it was that easy to find winners all the time, we’d all be a lot happier – even come tax time these days.
Planning around Section 1244
Section 1244 limits who can claim the ordinary income loss to individuals, couples, and, in some instances, partnerships.
For an individual member of a partnership to make this claim, you need to have been a member of the partnership when the stock was acquired and stayed a member for the entire time the stock was owned.
As an added benefit, 1244 losses are treated as a trade or business loss for computing an individuals’ net operating loss (NOL). As a result, losses attributable to Section 1244 are allowed for NOL purposes without being limited to nonbusiness income. What does this mean?
Let’s assume I invest $100,000 into a C Corp making widgets in 2010. Five years later, in 2015, the business collapses and I lose all my money in it. At the same time, I quit my job in late 2014 and only had $25,000 of income for all of 2015. Since my stock is treated as a NOL, I can use $25,000 of the loss in 2015 AND carry-forward the remaining $75,000 of loss to the following year (technically you can carry it back for two years or carry it forward for up to 20 years). Pretty cool.
However, if I had invested $200,000 into the Widgets C Corp in 2010 while watching the business fail in 2015 and I had $500,000 of other income, I would only be able to use $100,000 of the loss to offset other income. The remaining $100,000 ($200,000 – $100,000) would be treated as a long-term capital loss and used to offset capital gains in the future. Any carry-forward for next year would simply be treated as capital loss.
With that being said, if I tried to sell my stock in the company for $50,000 in 2015, I’d be better off from a tax perspective to try to sell it over two years to maximize my tax benefit. Notwithstanding, selling failing, illiquid small business stock over two years may not be possible and the stock could be worth much less by waiting until the new tax year.
Summary
The tax code provides lots of opportunities for those who understand them. Next time, we will talk about Section 83(b) of the tax code and how that directly impacts the holding periods of Sections 1202, 1045, and 1244. These provisions can be utilized together when the
Many area professionals are not aware of the provisions of the tax code as they relate to startups. Seek out advisors who can engage in deeper dialogue on the interplay between the various provisions of tax code relevant to founders and investors.