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[caption id="attachment_42974" align="alignleft" width="176" caption="DJ Drennan"][/caption]

Although most entrepreneurs and investors know that gains recognized on the sale of stock held for more than one year will be taxed at capital gains rates, many are not aware that gains recognized on the sale of certain types of stock could be entirely free from federal tax, but only if they act fast. 

 Since 1993 federal tax law has provided for a reduced federal capital gains tax rate on "qualified small business stock" (QSBS), as defined in Section 1202 of the Internal Revenue Code of 1986.  The reduction came in the form of an exclusion of 50 percent of the gain from capital gains taxes, with the remaining 50 percent subject to capital gains tax at the pre-1997 rate of 28 percent, resulting in an effective rate of 14 percent. 

 As a result of stimulus measures from Washington, the applicable exclusion rate was increased to 100 percent for the sale of QSBS that was purchased after Sept. 27, 2010 and before Jan. 1, 2012.  In other words, for a limited time only, the sale of certain QSBS may be subject to a zero-percent federal tax rate, a complete federal income tax exemption.  The 0 percent federal tax rate applies for purposes of both regular federal income tax and alternative minimum tax (AMT).  These measures are designed to encourage new investments and stimulate the economy and are particularly useful for startups trying to attract capital in today's difficult market.  QSBS requirements. 

 To qualify for the 0 percent federal tax rate on the gain from the sale of QSBS, a number of requirements must be satisfied, including the following (subject to exceptions, limitations, and qualifications that are beyond the scope of this brief article): The investor must not be a corporation.  Pass-through entities such as LLCs taxed like a partnership (or S corporations) can be an important planning tool, particularly as a holding company, since pass-through treatment is available with respect to a non-corporate investor's share of gain recognized by the LLC on the QSBS of a C corporation subsidiary. The non-corporate investor must hold the stock for more than five years after the date of purchase. The non-corporate investor must acquire the stock at original issuance, meaning a purchase of newly issued shares directly from the corporation, not a purchase of existing shares from an existing shareholder. The consideration paid for such stock must generally comprise of paying money or transferring property (not including stock unless it is also QSBS).  The issuing corporation must be a domestic C corporation.  The issuing corporation must be a "qualified small business" on the date the QSBS is issued, which requires, among other things, that the corporation's aggregate gross assets do not exceed $50 million.The issuing corporation must be engaged in a "qualified trade or business" during substantially all of the holding period. The issuing corporation must not have engaged in significant redemptions of stock held by the non-corporate investor at certain times before and after the issuance of the QSBS.  The redemption rule helps to achieve the policy goals of the QSBS rules, which are designed to encourage investment in new corporations. Maximum limit. 

 In addition to the above requirements, the amount of gain that is eligible for the 0 percent tax rate is subject to a maximum limit, which is computed on a per-investor, per-issuing corporation basis.  For any one non-corporate investor, the maximum amount of eligible gain is essentially the greater of $10 million or 10 times the investor's basis in the QSBS. 

 In conclusion, there are significant tax savings opportunities that deserve consideration, but entrepreneurs must act fast by forming an eligible C corporation and issuing QSBS by the end of the year. ...

DJ Drennan is a partner with Spaulding McCullough & Tansil LLP, 90 South E Street, Suite 200, Santa Rosa, CA 95404.  He can be reached at 707-524-1900 or drennan@smlaw.com.