Whether you”™re saving for retirement or simply putting your money to work, a diversified investment portfolio is important. Although it doesn”™t guarantee against loss, diversification is a widely advised approach to reaching long-range financial goals while minimizing risk.
There”™s one way to diversify your portfolio that”™s gained some major steam in recent months. Late last year, Congress passed the Protecting Americans from Tax Hikes Act of 2015 (the PATH Act). One of the law”™s key provisions imbued qualified small business (QSB) stock with a substantial tax benefit that investors should consider in their efforts to achieve optimal diversification.
HAVE YOU HEARD THE NEWS?
A provision of the Internal Revenue Code allows noncorporate taxpayers to exclude from gross income a certain percentage of gains realized from QSB stock ”“ under specified rules and limits, of course. To this end, the PATH Act made permanent the exclusion of 100 percent of the gain on the sale or exchange of QSB stock acquired and held for more than five years.
The stock in question must have been acquired after Sept. 27, 2010, though smaller exclusions are available for QSB stock acquired earlier. In addition, the PATH Act permanently extended a rule that eliminates QSB stock gain as a preference item for alternative minimum tax purposes.
WHAT ARE THE RULES?
As straightforward as the PATH Act”™s changes may seem, the rules for excluding gains from QSB stock remain fairly complex. So be sure you understand all requirements before you invest and then seek to exclude any gains on your federal tax return.
For starters, to qualify as QSB stock, the stock in question must have been issued after Aug. 10, 1993, by a C corporation with no more than $50 million in gross assets before and immediately after issuance. Furthermore, the issuing company needs to have at least 80 percent of its assets (by value) in one or more qualified trades or businesses. Notably, this requirement excludes several types of businesses, such as:
- Professional and personal services,
- Banking and other financial services,
- Farming,
- Restaurants and
- Hotels.
The QSB stock rules also stipulate that the stock in question must have been acquired on original issuance (directly or through an underwriter) by a noncorporate taxpayer in exchange for money or property (other than stock) or as compensation for services.
IS THE TIMING RIGHT?
The high amount of the QSB stock exclusion might inspire many investors to leap at the chance to claim it. But anyone who may think about cashing in stock and buying newly issued stock to take advantage of the now-permanent 100 percent exclusion should think again.
Section 1202 of the Internal Revenue Code contains explicit rules disqualifying stock if the company redeems stock from you or a related person within two years before the new stock is issued. And to prevent any investor from acquiring new stock first and then selling old stock back to the company, the provision also disqualifies stock from tax-free treatment if the company redeems anyone”™s stock within two years after the new stock is issued.
There are detailed rules on many other issues, including calculation of a corporation”™s gross assets, evaluation of a corporation”™s compliance with the active business requirement and treatment of stock held by partnerships and other pass-through entities. Also, the amount of gain you can exclude with any one corporate issuer is generally limited to the greater of $10 million or 10 times the adjusted basis of the QSB stock.
WHO CAN HELP?
Small businesses play an important role in the national economy. Because of this, the federal government looks to tax breaks such as the QSB stock exclusion to spur investment in companies of this size.
As an investor, you may look to QSB stock to more effectively diversify your portfolio while reaping the now substantial and permanent tax benefits.
This has been a general discussion for information only and is not intended as advice to anyone. The subject is complex, so check with your tax adviser before making any investments.
Norman G. Grill is managing partner of Grill & Partners LLC, certified public accountants and advisers to closely held companies and high-net-worth individuals, with offices in Fairfield and Darien. He can be reached at 203-254-3880 or at N.Grill@GRILL1.com.
