On September 13, 2021, the House Ways and Means committee released proposed amendments to the Build Back Better Act which would impact QSBS treatment
The release of the markups to the Build Back Better Act have QSBS investors and founders worried about their eligible tax exemption. The House of Representatives has made edits to the plan, including the American Jobs Plan and the American Families Plan, in order for the budget resolution to be passed by the Senate with a simple majority vote.
The changes applicable to Qualified Small Business Stock involve, for the first time, the adjusted gross income of the shareholder. The proposal, as is, would differentiate between taxpayers who make above $400K and those who fall below that threshold, similar to the proposed capital gain hike.
For QSBS holders who have less than $400K in annual adjusted gross income, the 100% federal tax exclusion will still hold even if the bill is passed, but for those who make more, only a 50% exclusion could be possible.
Taxpayers who make more than $400K must now consider their income in combination with the date of issuance to determine the percent of exemption they are eligible for.
CapGains Inc. is following this legislation closely and is forming a coalition to stay abreast of developments – keep up to date here.
The following portions of this article are from May 7, 2021
Last week, President Biden more clearly laid out his “Build Back Better” plan in front of congress with the associated American Jobs Plan and American Families Plan. High-income investors, having had time to digest these proposed changes and cutoffs to the TCJA of 2017, are surely now feeling uneasy, not only about their federal income taxes, but also about their previously lucrative capital gains taxes.
This article will lay out some of Biden’s “common-sense” tax reforms that seem to only affect the wealthiest individuals and corporations in America.
Biden’s Proposal for Federal Income Taxes
Biden’s “tax hikes” are really just a return to historical tax rates after eliminating tax cuts laid out by the Tax Cuts and Jobs Act of 2017.
Under TCJA and under the Trump Administration, taxpayers in the highest income tax bracket have been paying a maximum of 37 percent federal income tax on their annual taxes. President Biden’s proposed change to this rate is only an increase of 2.6 percent which raises the highest tax bracket back to what it was under the George W. Bush administration.
This raise would only affect individuals making $518,401 or more in annual taxable income, which Biden says represent less than 1 percent of the American population. It was, after all, one of Biden’s leading campaign agendas that our country was in need of tax reform that rewards work – not wealth.
Biden’s Tax Hike for Capital Gains
While an increase of 2.6% may not seem like enough to start fretting over taxes, especially for anyone not reaching the threshold of the highest income tax bracket, there is an even smaller population of American taxpayers who will be more harshly affected taxwise by Biden’s new tax reform proposal.
There are currently only 3 tax brackets when it comes to the income made on the sale of long-term stocks. For a shareholder who claims capital gains on the sale of stocks that have been held for over a year, the most one would pay in taxes is only 20 percent and that is only for individuals who have an annual taxable income of over $400,000.
In addition to this, under TCJA, investors can claim a $50,000 deduction on capital gains when filing their taxes. Simply put, they are excluding $50,000 from their taxable income and will only pay taxes on any capital gains that exceed that amount.
It is the opinion of the Biden administration that it is unfair and unjust that the richest American’s pay a smaller percentage of taxes on their capital gains income than what working class citizens pay on their regular taxable income.
Afterall, individuals who earn less than and around $40,000 a year in taxable income pay a higher rate, 22 percent or more, than investors who earn $400,000 in regular annual income pay on the long-term capital gains of their stock.
Because of these facts, and in order to recoup money from somewhere to fund the vigorous goals of both the American Jobs Plan and American Families Plan, Biden’s proposal requests an increase in the highest tax bracket on capital gains from 20 percent to 39.6 percent.
This increase of 19.6 percent is a number big enough to generate uneasiness in the investment community. However, this proposed bracket will only apply to investors who have a taxable regular income of $1,000,000 or more.
The fact that individuals making more than $518,401 in regular taxable income represents only 1 percent of the American population, can loosely illustrate the amount of taxpayers who are claiming both $1 million plus in regular income AND reaping the benefits of profitable capital gains.
What is the Difference Between Traditional Capital Gains and QSBS Capital Gains?
High and mid income earners alike, may ingest all of this information and conclude that they have missed the lucrative profitability of long-term capital gains. This is where section 1202, if not previously known, may seem like a saving grace.
QSBS is described in section 1202 of the Internal Revenue Code, or IRC, as a type of stock that, while specific, is not subject to the same high tax rates as other traditional stocks. An investor can actually and legally, exclude up to 100 percent of capital gains on QSBS from their taxable income, paying possibly $0 on any revenue resulting from their investments.
This section of the Code benefits all taxpayers, whether they make over $1,000,000 annually or under $40,000, and seems to remain in the safe zone in spite of Biden’s proposed tax hikes.
What is QSBS?
You probably are, and should be, excited and curious about this new term QSBS. Although not actually new, QSBS has been around since 1993, the benefit of understanding QSBS and section 1202 became even greater to taxpayers in 2012.
Section 1202 originally outlined that QSBS purchased or exercised after the Revenue Reconciliation Act of 1993 would come with the benefit of being able to exclude 50 percent of the capital gains from your taxable income. 50 percent exclusion from taxes may seem enticing to investors who’ve been sitting on stock for 3 decades, but what about those of us with less tenure in the investment game?
Thanks to the American Taxpayer Relief Act of 2012, Americans can now, under certain circumstances, exclude 50 percent, 75 percent, or possibly even 100 percent of the capital gains from eligible QSBS on their taxable income.
You read that correctly: Exclude 100 percent of capital gains from QSBS on your taxable income.
There is a limit on this exclusion, however, a taxpayer can only exclude 100 percent of the capital gains up to $10,000,000 or 10 times the adjusted basis of the initial stock.
How Do I Know How Much I Can Exclude?
The 50 percent, 75 percent, and 100 percent exclusion rates are dependent upon the acquisition date of the stock. Qualified Small Business Stock (QSBS) acquired by an individual after December 31, 1993 is eligible for a 50 percent exclusion of capital gains. The gains on QSB stock acquired between February 17, 2009 & September 26, 2010 benefit from a 75 percent exclusion. And finally, QSBS acquired after September 27, 2010 is subject to 100 percent exclusion from capital gains taxes.
What Makes a Stock QSBS Eligible?
While the benefits of receiving capital gains from QSBS are seducing, the qualifications that must be met by both the business and the shareholder may lose some of their appeal in the nitty gritty details.
There are many time-based and money-based criteria that must be met first for a business to be recognized by the Internal Revenue Service as a qualified small business. Firstly, the business must be filed as a domestic c corporation. An LLC, partnership, and S corporation will not qualify, according to the Code, as a QSB.
Next, the business must be involved in an approved trade. In short, most product-based businesses qualify where most service-based businesses don’t but here is a more comprehensive list of what doesn’t qualify from the code itself.
The fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees, any banking, insurance, financing, leasing, investing, or similar business, or any farming business, and any business of operating a hotel, motel, restaurant, or similar business.
Another stipulation in place by the code is that the company must be actively engaged in business. This has been simplified by many to mean that 80 percent of the business assets are being used to run the business.
The last criteria for the business itself to meet is called the aggregate gross asset test. In order for a corporation to be considered a Qualified Small Business by the IRS, it must have less than $50,000,000 in gross assets. Once a company exceeds this threshold, even if it were to come back down again in the future, it will no longer be considered a QSB and therefore any shares sold after that time would not qualify as qualified small business stock.
Now we take a look at the requirements placed on the shareholder in order to qualify for the section 1202 exemption.
Once a company is identified as a true QSB, the taxpayer must receive their shares directly from the company in order to be able to benefit from the exclusions in section 1202 later down the road. This is often seen when a new small business offers stock options to their employees.
Additionally, the shareholder must hold the stock for a minimum of 5 years before any capital gains are considered long-term investments rather than regular income. This is a great deal longer than the traditional 1 year holding period to claim capital gains in order to increase stability for new, growing businesses.
Don’t forget that even if a corporation no longer qualifies as a QSB, your shares that were purchased or exercised within a certain time, and before the gross-asset test was surpassed, may still qualify for the QSBS tax exclusions outlined in section 1202.
Low-Mid Income Earners and QSBS
QSBS and the codes that surround it are nothing more than an incentive for American taxpayers and investors to invest in small businesses. It is no longer true and will be even less true in the future that those who were smart enough or lucky enough to “get in early” on companies like Tik Tok and Uber, or can afford the stock prices of already successfully trending businesses, are the only ones who can get rich from capital gains.
Working class people should understand that by learning what you can about QSBS, you are setting yourself up for tax-free capital gains regardless of your income.
If Biden’s proposal goes through, taxpayers in those higher income brackets will surely be looking for places to put their money that will most benefit them and QSBS will be their answer.
Will the Biden Administration protect the exclusion of capital gains from QSBS?
President Biden’s entire campaign was run on the theory that he will not take away from the lower and middle class. It has been reiterated that the only target of his tax hikes are the wealthiest individuals in our nation as well as the corporations that have been given multiple bail outs as well as have been guilty of breaking or even evading tax laws.
When congress was making tax decisions as we approached the fiscal cliff of 2013, Biden accused Republicans of “holding middle-class tax cuts hostage” in order to appease the financial desires of the top 1 percent of American taxpayers. It was pointed out that 97 percent of American small businesses would hold onto their tax cuts under the democratic-favored proposal, and even the remaining 3 percent would retain a portion of their respective cuts.
During the 2020 Democratic presidential primaries, the Biden-Sanders Unity Task Force released their common goal that taxes should be used as a tool to “reduce inequality and concentrations of wealth as a way to pay for investments in U.S. productivity.” This has been demonstrated through Biden’s presidential proposal to only raise taxes on the highest earners in both the federal income tax bracket and the capital gains tax brackets.
In his recent address, Biden’s support for small businesses and everyday workers was exhibited by his statement that America should be built back “from the bottom and middle out” and that trickle down economics was an inaccurate theory kept alive by the wealthy.
Because of these several observations over many years and terms, it is fair to assume that the Biden administration will continue to support the relief offered to those investors who agree to invest in the bottom, the small, the growing businesses rather than the uber rich investing in the uber rich.
Robert Jackson is a tax accountant, who practices in Illinois. The views expressed in this article are his alone and do not necessarily express the views of QSBS Expert / CapGains Inc.
This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.