In the event of an M&A transaction, many stockholders plan to take advantage of the exclusion from federal taxable income of gain realized from the sale or exchange of “qualified small business stock” (QSB stock).  Section 1202 of the Internal Revenue Code (the Code) permits non-corporate stockholders to exclude from federal taxable income a portion of the gain realized from the sale or exchange of QSB Stock held for more than five years, subject to certain caps described below.

Although gain may be excluded for federal income tax purposes, stockholders should be aware that the state tax treatment may differ, and a stockholder may be subject to state taxes on the sale or exchange of QSB stock even where federal income taxes do not apply.

In this post, we highlight key considerations for stockholders planning to take advantage of the exclusion from federal taxable income of gain realized from the sale or exchange of QSB stock and discuss notable irregularities in state tax laws that investors should watch out for. Please contact us with questions you have about eligibility for QSB stock treatment and state tax treatment of QSB stock. To stay updated with our writings on developments impacting the M&A and private equity worlds, subscribe to the Material: WilmerHale M&A blog.

Eligibility For QSB Stock Treatment

Generally, stock is treated as QSB stock for federal income tax purposes only if the following requirements are satisfied:

• The issuer is a domestic C corporation as of the date of issuance, and neither it nor any predecessor corporation had aggregate gross assets in excess of $50 million at any time prior to or immediately after the issuance.
• During substantially all of the stockholder’s holding period, the issuer used at least 80% (by value) of its assets in the active conduct of one or more “qualified trades or businesses.”
• The stock was acquired by the stockholder at its original issuance in exchange for cash or property (other than stock) or as compensation for services. Certain redemptions during the four-year period beginning two years before the issuance of what would otherwise qualify as QSB stock may cause such stock not to qualify.

Limitations on Exclusion of Gain

For QSB stock acquired after September 27, 2010, the exclusion is 100% of the gain, but the amount a stockholder may exclude with respect to the stock of a given issuer cannot exceed the greater of $10 million or ten times the stockholder’s adjusted basis in the stock. For QSB stock acquired earlier, the percentage of gain that may be excluded is either 50% or 75%, depending on the date of acquisition, and the gain not excluded is generally subject to federal income tax at the rate of 28% rather than the reduced rates otherwise applicable to net capital gains.

If QSB stock is held through a partnership, including an investment fund that is a partnership for tax purposes, the $10 million or ten times basis limitation is not applied at the partnership level but instead is separately computed by each individual or trust holding an interest in the QSB stock through the partnership. However, the individual’s or trust’s exclusion is limited to the gain attributable to the partnership interest held by the holder on the date the partnership acquired the QSB stock.

State Tax Consequences Generally

Even when income is exempt from federal income tax, it may still be subject to state taxes, depending on the state(s) in which the stockholder is subject to taxation.  A stockholder is generally subject to taxation in the state(s) in which the holder is located or resides. Many state income tax laws conform to the Code, including the federal definition of gross income, while others do not.

To plan effectively and avoid costly surprises, stockholders should be aware of states that do not conform to the Code or have state-specific provisions regarding QSB stock. Irregularities in state tax laws that investors should watch out for include:

• States that do not conform to the Code. Some states, including Mississippi, New Jersey and Pennsylvania, impose a personal income tax that does not conform to the Code, including Section 1202. In these states, gains on the sale or exchange of QSB stock generally will be subject to tax in the state like other capital gains. Although Arkansas tax law does not conform to the Code generally, it does specifically conform to Section 1202 of the Code.
• States that conform to the Code in part but specifically modify the Section 1202 benefit. Although a state may conform its tax law to the Code generally, the state may have specific provisions that modify the treatment of QSB stock in the state. States with such provisions include Alabama and California, which generally do not allow any exclusion for gain from the sale or exchange of QSB stock, and Hawaii and Wisconsin, both of which only provide a 50% exclusion for gain from the sale or exchange of QSB stock (even where the sale qualifies for the 100% federal tax exclusion). In Wisconsin, the exclusion is further limited to gains on stock acquired after 2013.
• States that conform to the Code as of a specific fixed date. Many states conform their tax laws to the Code as of a fixed date. Because this fixed date may not be current, the tax laws in some states previously did not match the current federal treatment of QSB stock. As a result of the recent Massachusetts law change described below, all states (except for those described in the preceding bullet) that conform their tax laws to the Code as of a fixed date now fully recognize the 100% federal exclusion for the sale or exchange of QSB stock.

A Closer Look at Three Key States

The state tax treatment of QSB stock in California, Massachusetts and New York is generally as follows: 

• California. Because California generally does not allow any exclusion for gains from the sale or exchange of QSB stock, such gains are subject to California state tax even when exempt from federal income tax under Section 1202. California personal income tax rates currently range up to 13.3%, depending on income level.
• Massachusetts. As a result of a recent change in Massachusetts tax law, noncorporate taxpayers in Massachusetts can generally take into account the full available federal tax exclusion for sales of QSB stock on or after January 1, 2022. For sales prior to that date, the exclusion under Section 1202 is generally limited to 50%. However, Massachusetts also has a special rule providing a reduced rate of tax for sales of stock in certain small business corporations domiciled in Massachusetts, which may be available, both before and after January 1, 2022, for sales that do not qualify for the full federal exclusion.
• New York. New York tax law conforms to the federal treatment of QSB stock. Taxpayers subject to New York State or New York City personal income tax can generally take into account in computing those taxes the full exclusion that is allowed to them for federal income tax purposes.