The “Protecting Americans from Tax Hikes” (PATH) Act was recently signed into law, and two provisions in particular benefit venture capital, private equity, and other investors owning or planning to purchase a corporation.

Qualified Small Business (“QSB”) Stock

Tax break for those who invest in certain early stage or “start-up” companies.  

Background.  Non-corporate taxpayers who acquire QSB stock in a C-corporation at original issuance, hold such stock for more than 5 years, sell such stock at a gain, and meet certain other requirements, may exclude all or a portion of that gain from taxable income.  Without this exclusion, gain from the sale of the stock will generally be subject to capital gains tax.  

The change — complete tax exclusion extended.  The percentage of the gain excludable is 50%, 75%, or 100%, depending on the date on which the QSB stock was acquired.  With the enactment of the PATH Act, the 100% exclusion percentage is extended indefinitely, and is no longer scheduled to “sunset.”  The full exclusion previously applied on a temporary basis to stock acquired after September 27, 2010 and through 2014, but now applies indefinitely to stock acquired in 2015 and thereafter.  

Requirements / limitations.  Certain other requirements must be satisfied in order to qualify.  For instance, the corporation in question must not be engaged in a variety of ineligible businesses (e.g., many service businesses, financial businesses, farming, natural resources, hotels, and restaurants).  In addition, the corporation’s aggregate gross assets must not exceed $50 million (measured using special rules) at any time up until and immediately after the original stock issuance.  With respect to each taxpayer qualifying for the income exclusion, the amount of gain that can be excluded is generally limited to the greater of $10 million or ten times the tax basis the taxpayer had in the QSB stock when it was first acquired.  

The $50 million limitation, coupled with the 10 times basis limitation, yields a potential exclusion of up to $500 million of gain for each eligible shareholder, making the QSB stock exclusion quite attractive for some.  

Recommendation.  Non-corporate investors in small businesses should be aware of this potential tax advantage, and may want to consider structuring investments with an eye on the QSB stock gain exclusion, including weighing the benefits of the exclusion against the benefits of flow-through taxation when choosing entity structure.  In addition, investors should consider whether a currently-held investment might qualify under the rules in the event of a sale of stock.  

S-Corporation Built-in Gains Tax

Tax planning opportunity when acquiring a C-corporation with built-in gain assets.  

Background.  Unlike a C-corporation, an S-corporation is generally not subject to entity-level taxation, but rather its income flows through to its shareholders.  Therefore, while a C-corporation must pay tax on its sale of any appreciated assets (and then its shareholders must pay a second level of tax on a dividend distribution by the C-corporation), an S-corporation does not pay such tax (and thus there is no “double” taxation).  

The Change.  To prevent avoidance of the entity-level tax applicable to a C-corporation, a corporation with appreciated assets that elects to convert from C to S-corporation status is taxed on a post-conversion sale of any such appreciated assets, to the extent of built-in-gain at the time of conversion, if the sale occurs within a prescribed period after conversion.  The law initially set the period at 10 years, but the period was temporarily reduced to 7 and then 5 years during the economic downturn.  The 5-year recognition period has been extended indefinitely.  

Recommendation.  C corporations that are eligible to elect S status, or that would be eligible to make an S election if they restructured, should consider the benefits of the new rule in deciding whether to convert to an S corporation, or restructure to enable conversion.  S status can be particularly beneficial to corporations that pay regular dividends or if a sale of the business is expected.  

In addition, the previous 10-year period was usually beyond the planning horizon of most investors, and thus there were probably few acquisitions made with an eye on avoiding the corporate level income tax.  With the adoption of the 5-year period indefinitely, investors purchasing a corporation should consider the potential advantage of structuring for S corporation eligibility.  For instance, investors may purchase a C-corporation holding assets with a low tax basis, convert the target to an S corporation, and sell its assets after 5 years, avoiding entity-level tax attributable to any built-in gain in the assets that existed at the time of the conversion to S-corporation status, while still providing the buyer with a step-up in basis at no additional cost to the seller.