INTRODUCTION

Many U.S. investors and business owners are familiar with the tax exemption provided to U.S. individuals recognizing gains from the sale of certain U.S. stock defined as qualified small business stock ("Q.S.B.S.").1 The Q.S.B.S. exemption plays an important role in the growth of hi-tech industry, which is dependent on investments by U.S. persons. It typically benefits U.S. individuals who invest in start-up software companies.

The Q.S.B.S. exemption is not available for investment gains related to shares of stock of corporations engaged in a business involving the provision of specified nonqualified service. In recent years, many start-up software companies have focused on the development of technological tools to provide automated services. Some of those services are of a type considered to be nonqualified business activity for Q.S.B.S. purposes. This raises several interesting questions:

  • Will investment gains in these software companies qualify for the Q.S.B.S. exemption?
  • In what circumstances are the software companies considered to be providers of nonqualified services?
  • In what circumstances are the software companies only providing software tools that are sold to service providers?

This article addresses those questions.

THE GENERAL FRAMEWORK OF THE Q.S.B.S. EXEMPTION

Code §1202 provides that gains from the sale of qualified small business stock held for more than five years are not included in the taxable income of a U.S. individual shareholder.2 The exempt amount is the greater of $10 million or 10 times the aggregate basis in the stock held in the Q.S.B.S.3

To qualify for the Q.S.B.S. exemption, the following requirements must be met with regard to the issuer of the stock:4

  • A U.S. Corporation. The corporation must be incorporated in the U.S.5 or under the laws of one of the states of the U.S.6 The U.S. corporation cannot be a D.I.S.C., former D.I.S.C., R.I.C., R.E.I.T., R.E.M.I.C., or cooperative.7 In addition, neither an L.L.C. that has not elected to be taxed as a corporation nor an S-corporation that generally is not subject to corporate tax in the U.S. is considered to be a corporation for purposes of the Q.S.B.S. exemption.
  • An Active Business. The corporation must be engaged in an active qualified business as defined in Code §1202(e) during substantially all of the shareholder's holding period for the stock.8 This requirement is at the center of this article and is further discussed below.
  • A Small Business. The aggregate gross assets of the corporation, including money, must not exceed $50 million both before and immediately after the issuance of the stock.9 The aggregate gross assets amount is measured by the adjusted bases of the assets the corporation.10 For this purpose, all corporations that are members of the same parent-subsidiary controlled group are treated as one corporation.11
  • Originally Issued Stock. The stock must have been originally issued to the U.S. individual in exchange for money or property other than shares. Stock originally issued as compensation for services also qualifies. Certain exceptions apply. Stock acquired by gift, bequest, or as a distribution from a partnership generally will qualify if the transferor was the holder of the originally issued stock.12 Stock held through pass-through entities generally are treated as originally issued stock.13

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Footnotes

1. Section 1202 of the Internal Revenue Code of 1986, as amended (the "Code"). The Q.S.B.S. exemption was enacted to incentivize investment in U.S. corporations as a vehicle for business start-ups. For many years, the exemption was limited to 50% or 60% of the gain. The limitation was removed by the Tax Cuts and Jobs Act of 2017.

2. Code §1202(a)(4).

3. Code §1202(b)(1). However, for stock purchased before 2010, the exemption is limited to 50% of the gain derived on the sale. See, Code §§ 1202(a)(1) & (4).

4. Code §§1202(c), (d) & (e).

5. A corporation formed in the District of Columbia is clearly included as a corporation formed in the U.S.

6. Code §1202(d)(1). A domestic corporation is defined in Code §7701(a)(4).

7. Code §1202(e)(4).

8. Code §1202(c)(2)(A).

9. Code §1202(d)(1).

10. Code §1202(d)(2)(A).

11. Code §1202(d)(3). The term "parent-subsidiary controlled group" means any controlled group of corporations as defined in section 1563(a)(1), except that more than 50%-ownership is the measuring stick rather than at least 80%.

12. Code §1202(h).

13. Code §1202(g).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.