Those who hold qualified small business stock (QSBS) have dreams at night about selling their shares and receiving the proceeds tax free.[1]
Lately, however, I’ve seen a number of stockholders wake up from that dream in a cold sweat. Why? The company is being sold and the stockholder has not quite met the 5-year holding period requirement.
Here’s the good news: Section 1045 of the tax code allows a stockholder to take proceeds that would otherwise be taxable and reinvest them within 60 days of the sale of their shares into a new qualified small business. This not only defers the federal tax (and in some states the state tax), but potentially eliminates it if the new stock is not sold until more than 5 years after the date the original stock was acquired.
Here’s the bad news: A stockholder in this predicament cannot just open up a new C corporation, dump the sale proceeds into it, and then liquidate the new corporation once the 5-year holding period has been met.
That said, there is nothing prohibiting a stockholder from rolling the proceeds into a business that he already owns, or even one that he starts within the 60-day rollover period. The key is, this new business needs to be actively engaged in a trade or business.
As a quick refresh, for stock to get the QSBS 0% federal income tax rate:
- Original Issuance: The stock must have been originally issued to the stockholder from a domestic C corporation;
- Holding Period: The stock must be held for more than five years prior to the date of sale;
- $50M: The issuing company must have had less than $50M (from the date of formation through the date the stock in question was issued) of (i) cash + (ii) asset basis of created assets + (iii) fmv of contributed assets on date of contribution;
- Industry: The issuing company must be in an allowable industry (software is ok, consulting, restaurants, hotels, and other service companies generally are not);
- Active Business: The issuing company must have been engaged in an active business during substantially all of the stockholder’s holding period;
- No Significant Redemptions: The C corp cannot make significant repurchases of its own stock within a certain time period of the stock issuance.
The Active Business Test
The corporation must use at least 80% (by value) of its assets in the active conduct of one or more qualified trades of businesses, during substantially all of the stockholder’s holding period.
The 80% threshold is lowered if the excess assets are being kept for working capital or R&D needs. For C corps that have existed two years, my rule of thumb in applying the active business test is to compare the enterprise value of the Company determined by the 409A valuation to the amount of cash and other short-term investment assets on the company’s financial statements, and to be comfortable only if the company’s valuation is at least 50% higher than the latter. So, for example, if there is cash and other short-term investment assets of $5M, then if the total value of the company is at least $7.5M, then we know that the former assets will be not more than two-thirds of that total and we’re ok under the relaxed threshold.
Additionally, the corporation fails the active business test, during any period in which more than 10% of the value of its assets (in excess of liabilities) consists of stock or securities in other corporations which are not subsidiaries, unless such amounts fit within the working capital asset/R&D exclusion.
Mike Baker frequently advises with respect to qualified small business stock rollovers. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.
[1] Remember, to get the 0% federal rate, you must have received your stock directly from the qualified small business after September 27, 2010. Most states match this 0%, though some states (notably California) do not provide any tax benefit with respect to a sale of qualified small business stock.