Eligible Shareholders     Can Uncover Benefits

Here is a rundown of the tax breaks that may be available to QSBC shareholders:

Break No. 1:

You can potentially exclude (not be taxed on) up to 50 percent of your gains from selling QSBC shares. However, the taxable portion of your profits (generally 50 percent) is taxed at a maximum federal rate of 28 percent, which works out to an effective 14 percent rate (50 percent times 28 percent equals 14 percent).

Of course, 14 percent is only marginally better than the 15 percent maximum federal rate on long-term gains from garden-variety stock investments. So under today’s federal income tax rate structure, the gain exclusion break isn’t worth much.

In addition, the gain exclusion privilege is available only when you sell original-issue shares (issued by the company directly to you or to a person who gave the shares to you) that were issued after August 10, 1993. You also must have owned the shares for more than five years. (Source: Section 1202 of Internal Revenue Code)

Finally, 7 percent of the excluded gain amount is treated as a “preference item” for alterative minimum tax (AMT) purposes. That means it’s treated as additional income when calculating AMT. So if you owe AMT, your tax savings will be less than expected (and probably next to nothing) because of the additional AMT hit. (Source: IRC Section 57(a)(7))

Bottom Line: The gain exclusion break is nearly worthless under today’s tax rules. But as we'll explain below, owning QSBC stock can allow you to take advantage of another break that has some real tax-saving value.

Break No. 2:

Here’s where it gets interesting. You can potentially roll over (defer federal income taxes on) gains from selling QSBC shares, as long as you reinvest the sales proceeds in newly issued shares of another QSBC. This tax-free gain rollover break is significant because it allows you to indefinitely postpone paying any federal income taxes on all your QSBC stock sale gains — as long as you keep reinvesting all the sales proceeds.

The gain rollover privilege is available only when you sell original-issue shares acquired after August 10, 1993. To be eligible, you need only to have owned the shares for at least six months and a day. So it’s fairly easy to qualify for this second tax break, which is fortunate because it’s the really good one. (Source: IRC Section 1045)

How to Benefit from the Gain Rollover Break

You are eligible for this tax-saving deal if you’ve owned the QSBC shares for more than six months when you sell. Then, within 60 days, you must reinvest the sales proceeds in newly issued shares from another QSBC. Let’s call that new stock “replacement shares.” You can roll over (defer taxes on) your entire gain from the original batch of QSBC shares as long as you reinvest at least 100 percent of the sales proceeds in replacement shares. If you reinvest less than 100 percent, you are taxed on gain up to the difference between sales proceeds and the amount reinvested.

Under the rollover privilege, gain is deferred until you eventually sell the replacement shares. Even better, successive tax-deferred rollovers are permitted as long as each transaction meets the qualification rules explained above.

Example: Let's say you were issued 100 shares in FirstCo, a QSBC, on July 1, 2002. You paid $15,000 for the shares. On August 1, 2007 you sell them for $100,000. Within 60 days, you reinvest the $100,000 sales proceeds in newly issued shares of SecondCo, another QSBC. You elect to roll over your entire $85,000 gain from the FirstCo sale by reducing the basis of your new SecondCo shares to $15,000 ($100,000 paid for those shares less the $85,000 gain rollover). When you eventually sell your SecondCo shares, you can roll over some or all of your gain from that sale too by reinvesting in another round of QSBC replacement shares. (You must own the SecondCo shares for more than six months to qualify for the gain rollover privilege on those shares.) You must make a special tax return election to take advantage of the gain rollover privilege. Your accountant will report the entire gain from the QSBC stock sale on Schedule D of Form 1040, just as an investor usually would. Then, the amount of gain rolled over (deferred) will be shown as a negative number on the next line, along with the notation “Section 1045 rollover.” That way, you only pay federal income tax on the net number, which is zero if you reinvest all the sales proceeds in replacement shares. (Source: IRS Revenue Procedure 98-48)

Conclusion: The gain rollover privilege makes investing in QSBC stock an attractive proposition. However, not all small business corporation shares qualify. (See the right-hand box above for additional eligibility rules.) Consult with your tax adviser if you have questions about the QSBC tax breaks or if you own stock that you think may be eligible shares.

Estate Planning: Tax-Saving Bonus     If you still own QSBC shares when you die, the federal income tax basis of those shares will be stepped up to their date-of-death fair market value. That means your heirs can then sell the shares and owe no federal tax for any profits that accumulated during the years of your ownership. (Source: IRC Section 1014)