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Federal QSBS Exclusions and State Tax Implications
Allowing capital gains tax exclusions for Qualified Small Business Stocks (QSBS) encourages investment in US small business. QSBS laws help provide capital for these businesses while offering a savvy tax strategy for investors who want to minimize capital gains taxes.
Investors who hold qualified small business stock for at least 5 years can exclude up to $10,000,000 or more of their recognized capital gains from their taxable income if certain criteria are met.
Learn more about the criteria for Qualified Small Business Stock.
Each state has its own treatment of QSBS gains at the state income tax level. There are three ways in which states typically address the exclusion.
1. Some states fully conform to the Federal QSBS guidelines, and therefore allow a full exemption if the stock meets the Section 1202 QSBS criteria. Alternatively, certain states do not have state income taxes and therefore there is no QSBS implication at the state level.
2. Some states partially conform to the Federal QSBS guidelines, whereby the capital gains from QSBS are exempt if additional criteria beyond the Federal guidelines are met, such as only allowing exemptions if the QSBS gains were from a company doing business in that state.
3. Lastly, certain states do not allow any capital gains exclusions for QSBS.
Find out how QSBS is recognized by each state here.
California QSBS Exemptions
California no longer allows tax exemptions for QSBS although they previously had partially conformed to the Federal guidelines. These exclusions were outlined in California Revenue and Taxation Code sections 18152.5 and 18038.5 and were repealed in 2013. Specifically:
- Section 18152.5 stated that “gross income shall not include 50 percent of any gain from the sale or exchange of qualified small business stock held for more than five years.” The law went on to define the eligible gain for both single and married taxpayers, the criteria for a qualified small business, and specific stock-related criteria.
- Section 18038.5 defined gains and losses relative to the disposition of stock, rather than gains treated as ordinary income.
Various exclusions were allowed for gains made between January 1, 2008 and December 31, 2012, if certain conditions were met. Specifically:
- For shares that were purchased at original issue on or before February 17, 2009, there is a 50% exclusion.
- For shares that were purchased at original issue between February 18, 2009, and September 27, 2010, there is a 75% exclusion.
- For shares purchased at original issue between September 28, 2010, and December 31, 2011, the exclusion was bumped to 100%.
Conditions for the exclusion were as follows:
- At least 80% of payroll must have been to employees in California, and
- At least 80% of the assets were to be used in the conduct of business in California.
Both Section 18152.5 and Section 18038.5 were repealed in 2013, and so all capital gains are now taxed in California.
California Capital Gains Tax Rates
All capital gains in California are taxed at the same rate as an individual’s regular income. Unlike other states, there is no distinction between short-term and long-term capital gains. There are 10 income tax rates, and therefore capital gains tax rates, starting at 1% for those making less than $8,809 annually and progressing up to 13.3% for those making $1,000,000 or more in increments of 1-2%.
These numbers are true for single taxpayers. For married couples filing jointly, you can exactly double the income number to receive the same tax rate.
In comparison, federal capital gains tax rates only have 3 brackets for single taxpayers which are:
- 0% for $0 to $39,375
- 15% for $39,376 to $434,550
- 20% for $434,551 or more
History of the California QSBS Repeal
The California Court of Appeal ruled in August 2012 that the 80% requirements noted above were discriminatory. As a result of this ruling, the California Franchise Tax Board (FTB) found that there was no way to keep the valid portions of the statute while disregarding the invalid portions, and thus called the entire law invalid.
California Senate Bill 209, which amended and repealed Sections 18038.5 and 18152.5, and added Section 18153, was introduced in February of 2013. The bill passed in both the State Assembly and the State Senate in September 2013. It was then approved by the governor in October of that year.
The bill added language to both of the statutes clarifying the cutoff for what stock could be eligible for the QSBS exemptions and what would no longer be. In the case of 18038.5, the following provisions were added (new portions in italics):
18038.5(c) This section shall apply to sales made after August 5, 1997, and before January 1, 2013.
18038.5(d) This section shall remain in effect only until January 1, 2016, and as of that date is repealed, unless a later enacted statute, that is enacted before January 1, 2016, deletes or extends that date.
The new language added to 18152.5:
18152.5(m) The amendments made to this section by the act adding this subdivision shall apply to sales, including installment sales, occurring in each taxable year beginning on or after January 1, 2008, and before January 1, 2013, and installment payments received in taxable years beginning on or after January 1, 2008, for sales of qualified small business stock made in taxable years beginning before January 1, 2013.
18152.5(n) This section shall remain in effect only until January 1, 2016, and as of that date is repealed unless a later enacted statute, that is enacted before January 1, 2016, deletes or extends that date.
In addition to the amend and repeal language for sections 18038.5 and 18152.5, the bill added a new section to the Revenue and Taxation Code, section 18153. This section addressed how to handle tax situations arising on or after January 1, 2008, and before January 1, 2013, if the amended section 18152.5 was held invalid, ineffective, or unconstitutional by any appellate court. Section 18153 itself was then to be repealed:
18153(c) This section shall remain in effect only until January 1, 2018, and as of that date is repealed, unless a later enacted statute, that is enacted before January 1, 2018, deletes or extends that date.
Capital gains recognized after January 1, 2013 from the sale of qualified small business stock are no longer eligible for state tax exclusion in California.
This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.
