The Protecting Americans from Tax Hikes Act, passed in December 2015, extended an often overlooked provision of the tax code with the potential to provide significant savings to small business owners and non-corporate investors.  Section 1202 of the Internal Revenue Code permits the seller of a “qualified small business” to exclude up to 100% of the gain attributable to the sale or exchange of qualified small business stock from taxation.

Stock must have the following characteristics to be eligible for exclusion as “qualified small business stock” (QSBS):

1. The stock must be originally issued by a “qualified small business”.
2. The taxpayer must have acquired the stock at its original issue in exchange for money, property, or as compensation for services provided to the corporation.
3. During the time the taxpayer owns the stock, at least 80% of the corporation’s assets must be used in the active conduct of one or more qualified businesses.
4. The corporation must be an “eligible corporation” within the meaning of the statute.
5. The corporation must not have redeemed more than a de minimus amount of stock from the taxpayer (or certain related parties) during the four-year period beginning two-years prior to the issuance of stock to the taxpayer.

A “qualified small business” means a domestic “C Corporation” that did not have aggregate assets in excess of $50 million through and immediately following the issuance of the QSBS.  To meet the active business requirement, the corporation can generally operate any active trade or business other than certain excluded businesses.  Examples of excluded businesses include service businesses such as health, law and engineering, financial businesses such as banking, insurance and financing, and certain other businesses such as farming, mining and operating hotels or restaurants.

Sellers of QSBS held for more than five years may be eligible to exclude 50%, 75% or even 100% of their gain at sale.  QSBS acquired after September 27, 2010 is eligible for the 100% exclusion.  QSBS acquired before February 18, 2009 is eligible for a 50% exclusion; while stock acquired after February 18, 2009 but before September 27, 2010 eligible for a 75% exclusion.  The excluded gain is, however, limited to the greater of $10 million or ten (10) times the taxpayer’s adjusted basis in the QSBS.

If used correctly, the QSBS exclusion can provide a valuable tool for small businesses and investors.  As capital gains rates rise, tax efficient exit strategies become increasingly important for business owners to consider.