If your investments include stock in certain small businesses, you may be able to exclude part of your gain when you sell the stock, or you may be able to roll over part of the gain tax-free.
Tests for Qualified Small Business Stock
The following tests have to be met in order for the stock to be considered Qualified Small Business (QSB) stock:
The stock cannot be from an S corporation; it must be from a regular corporation, known as a C corporation.
The original issue date of the stock must be after August 10, 1993.
The corporation must not have had more than $50 million in total gross assets at any time on or after August 10, 2003, and before and after the original issue date of the stock.
You must have acquired the stock at its original issue (either directly or through an underwriter), either in exchange for money or other property or as pay for services (other than as an underwriter) to the corporation.
The corporation cannot have purchased more than a de minimis amount of its own stock from you or a person related to you during the period from 2 years before until 2 years after the stock was issued, and during the period from 1 year before until 1 year after the stock issue date, the corporation must not have purchased more than 5% of its own stock from anyone.
During substantially all the time you held the stock, the corporation must be an eligible corporation and at least 80% of its assets must be used in the active conduct of what is considered a qualified business.
What Is An Eligible Corporation?
In order to be Qualified Small Business stock, the corporation that issues the stock must be a U.S. corporation, not a foreign corporation, and cannot be any of the following:
Domestic International Sales Corporation (DISC),
A corporation that has made an election under Section 936 of the Internal Revenue Code regarding tax credits in Puerto Rico and U.S. possessions,
Regulated investment company,
Real estate investment trust (REIT),
Real estate mortgage investment conduit (REMIC),
Financial asset securitization investment trust (FASIT), or a
cooperative.
What Types of Businesses Qualify?
Qualified small businesses, for purposes of excluding part of the gain on the sale of the corporation’s stock, can include any type of business except the following, which are specifically excluded:
Professional services corporations, including businesses that offer services performed in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services.
Business whose principal asset is the reputation or skill of one or more employees.
Banking, insurance, financing, leasing, investing, or similar business.
Farming business.
Business involving the production of products for which percentage depletion can be claimed.
Business of operating a hotel, motel, restaurant, or similar business.
A specialized small business investment company (SSBIC) is considered to be engaged in the active conduct of a qualified business, and therefore qualifies.
Exclusion of Gain
If you hold stock in a qualified small business, you may be able to exclude part of the gain when you sell the stock. This is a provision of Section 1202 of the Internal Revenue Code, that provides for an exclusion of up to 50% of the eligible gain on the sale or exchange of Qualified Small Business (QSB) stock that is held for more than 5 years. And the taxable part of the gain is treated as a 28% rate gain.
How To Report
If you have a sale of qualified small business stock that you have held for more than 5 years, you would report the entire gain realized on the sale in the long-term capital gains section of Schedule D. Directly below the line on which you report the gain, you would enter "Section 1202 Exclusion" in column (a) and enter the amount of the allowable exclusion as a negative amount.
Rollover of Gain
If you sell stock that you held for more than 6 months, you may be able to postpone the gain by rolling it over. In order to do this you must purchase other qualified small business stock during the 60-day period that begins on the date of the sale, and this replacement stock must continue to meet the active business requirement for at least 6 months after you buy it.
If you elect to roll over the gain, you are effectively postponing the gain by adjusting the basis of the replacement stock. You make the election at the time you file your return for the tax year in which the QSB stock was sold. You would report the entire gain realized on the sale in either the short-term or long-term section of Schedule D, as applicable.
How To Report
Directly below the line on which you report the gain, you would write "Section 1045 Rollover" in column (a) and enter the amount of the postponed gain as a negative amount. This is the amount by which you would have to reduce your basis in the replacement stock.
Your holding period in the replacement stock would include the holding period of the qualified small business stock you sold, except for the 6-month holding period to qualify for the rollover.
Pass-Through Entities
If you held an interest in a pass-through entity, such as a partnership, an S corporation, a mutual fund, or other regulated investment company that sold QSB stock, you would qualify for the exclusion if you held the interest on the date the pass-through entity acquired the QSB stock and at all times thereafter until the stock was sold.
A distributed capital gain, from a mutual fund for example, would be reported on Form 1099-DIV. Part or all of the gain reported in box 2e of Form 1099-DIV may be eligible for the Section 1202 exclusion.
An undistributed capital gain would be reported on Form 2439. Part or all of the gain reported in box 1e of Form 2439 may be eligible for the Section 1202 exclusion.