Special Situations

What if My Company Merges or is Bought Out?

Rather than going public, many small businesses are ultimately acquired by larger companies. Fortunately, the law protects your QSBS tax treatment under this scenario.

Let’s assume your current shares will be converted into stock of the new company, which is too large to qualify as a small business. Under 1202(f), as long as your current shares are QSBS, your new shares shall be treated as QSBS as well. In addition, the new stock will be treated as having been held during the period during which the old QSBS shares were held.

For example, assume Mary has $6MM of QSBS shares she’s owned for three years, with a cost basis of $1MM. Her company is acquired by Oracle, and her shares are exchanged for an equivalent value of ORCL common stock.

After two years, she will be eligible for a QSBS capital gain exclusion upon selling her ORCL shares. Note that this tax treatment only applies to the Oracle shares acquired through conversion of the old stock. Any shares of Oracle she otherwise acquires will not be considered QSBS.

In addition, if the acquisition was considered a “section 368 reorganization” (which is often the case), Mary’s eligible gain will be limited to the appreciation as of the date of conversion.

For example, assume her ORCL shares grew to $8MM by the time they were sold two years later. She can only claim QSBS treatment for $5MM, or the gain that occurred up until the date of conversion ($6MM value minus $1MM basis). The $2MM gain in ORCL stock subsequent to the conversion date will be taxable as a regular capital gain.

Rollovers of QSBS Stock

Those who wish to sell shares of QSBS, but haven’t met the five year rule, can consider a 1045 exchange.

To qualify:

They must have owned the current QSBS shares for at least six months. They must purchase replacement QSBS shares within 60 days of selling the current shares. They must properly elect the deferral on their tax return for the year the current QSBS shares were sold, even if the replacement shares have not yet been purchased. The tax return for the year of sale containing the election must be filed before the due date (including extensions). To completely defer taxes, the entire sale proceeds from the current QSBS shares must be used in the purchase of the replacement shares. Any unreinvested amount will result in the recognition of gains. When properly executed, the cost basis and acquisition date of the current QSBS shares will transfer to the replacement shares.

Gifted or Inherited Shares of QSBS

Anyone receiving shares of QSBS from a gift or inheritance is treated as having acquired the stock on the same date and in the same manner as the original owner.

For example, assume Ted receives a gift of $1MM worth of QSBS from his parents, who properly acquired the shares six years ago. If Ted sells the shares the next day, he will qualify for QSBS tax treatment. In other words, he does not need to wait five years from receiving the shares. These transfer rules can create powerful financial and estate planning opportunities for those with large amounts of QSBS stock. For more details, see What to Do if You Have More than $10MM in QSBS.

QSBS Owned in a Pass-Through Entity

In general, under 1202(g), shares held in a pass-through must meet the same QSBS requirements an individual would face, such as the five year rule. In addition, if the pass-through meets the QSBS rules, individuals must hold the interest in the pass-through for at least five years in order to claim a capital gain exclusion on their personal return. In general, a transfer of originally issued QSBS to a pass-through will cause shares to lose their QSBS treatment. Pass-thru entities specifically outlined in 1202(g) include the following:

• Partnerships
• S Corporations
• Regulated Investment Companies (such mutual funds, UITs, closed-end funds, etc.)
• Common Trust Funds

Empowerment Zone Business Stock

You generally can exclude up to 60% (rather than 50%) of your gain from the sale or exchange of QSB stock held for more than 5 years if you meet the following additional requirements. 

1. The stock you sold or exchanged was stock in a corporation that qualified as an empowerment zone business during substantially all of the time you held the stock. 
2. You acquired the stock after December 21, 2000, and before February 18, 2009. 
3. The gain from the sale or exchange of the stock is attributable to periods on or before December 31, 2018. 

Requirement 1 will still be met if the corporation ceased to qualify after the 5-year period that began on the date you acquired the stock. However, the gain that qualifies for the 60% exclusion can't be more than the gain you would have had if you had sold the stock on the date the corporation ceased to qualify.