If you’re considering investing in a start-up or starting your own business in Maine, there’s an exciting tax break that could sweeten the deal: Gains from selling qualified small business stock (QSBS) that you acquire on or after September 28, 2010, are potentially eligible for a 0% federal income tax rate.

The 0% rate on QSBS gains is now permanent thanks to the Protecting Americans from Tax Hikes (PATH) Act of 2015. However, not all shares will qualify for the 0% rate, and you must own the QSBS for over five years. Here are some key points to help determine whether this tax break could work for you.

Here are the Basics

QSBS is stock in a C corporation that meets the definition of a qualified small business corporation (QSBC). In general, QSBCs are the same as garden-variety C corporations for all tax and legal purposes, but the only exception is that QSBS is eligible for favorable federal income tax treatment when and if it’s sold.

The following requirements must be met for shares to be QSBS:

• The issuing corporation must be a QSBC at the date of the stock issuance and during substantially all the time you hold the shares.
• The shares must be acquired after August 10, 1993, and they generally must be acquired upon original issuance or by gift or inheritance.
• The issuing corporation’s gross assets can’t exceed $50 million at all times on or after August 10, 1993, and before the stock is issued — and immediately after the stock is issued. If, after the stock is issued, the corporation grows and exceeds the $50 million threshold, it won’t lose its QSBC status for that reason.
• The issuing corporation must actively conduct a qualified business. Qualified businesses don’t include: 1) service providers in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services and other businesses where the principal asset is the reputation or skill of employees; 2) banking, insurance, leasing, financing, investing or similar activities; 3) farming; 4) production or extraction of oil, natural gas or other minerals for which percentage depletion deductions are allowed; or 5) the operation of a hotel, motel, restaurant or similar business.

It’s important to consult your tax advisor before concluding that you’re investing in a QSBC. The most important QSBC eligibility rules are summarized here, but there are more.

Timing is Critical

In order to determine how much of the gain can be excluded (ignored for federal income tax purposes) when the shares are sold, the acquisition date is critical for QSBS. The 0% tax rate — which equates to a 100% gain exclusion — is only available for sales of QSBC shares that are acquired on or after September 28, 2010.

You can potentially exclude (pay no federal income tax on) up to 75% of the otherwise-taxable gain for QSBS shares acquired between February 18, 2009 and September 27, 2010.

For QSBC shares acquired after August 10, 1993, and before February 18, 2009, you can potentially exclude up to 50% of the otherwise-taxable gain.

Important note. These gain exclusions aren’t available for QSBS owned by C corporations. However, shares held by individuals, S corporations and partnerships are potentially eligible.

You must hold the QSBS for over five years in order to take advantage of the gain exclusions. The 0% tax rate will only be available for sales that occur sometime in 2021 at the earliest for shares that haven’t been issued yet.

Limitations on Excludable Gains

Bear in mind that this is where things get complicated. Congress placed limits on the amount of QSBS gain that’s eligible for the aforementioned exclusions. In any tax year, your eligible gain — the amount of gain that qualifies for the applicable gain exclusion percentage of 100%, 75% or 50% — is limited to the greater of:

1. Ten times your aggregate adjusted basis in the QSBS that’s sold, or
2. $10 million (or $5 million if you’re married but filed separately) reduced by the amount of eligible gain already taken into account by you in prior tax years for sales of QSBS issued by the same corporation. In effect, the $10 million (or $5 million) restriction is a lifetime limitation.

Tax Rates on Taxable Portions of Gains

The amount of eligible gain that you can’t exclude (25% or 50% of the total eligible gain, depending on when you acquired the shares) is subject to a 28% maximum federal income tax rate. That translates into an effective maximum rate on eligible gains of either 0% if the 100% gain exclusion applies, or 7% if the 75% exclusion applies, or 14% if the 50% exclusion applies. You may also owe the 3.8% net investment income tax (NIIT) on eligible gains that you can’t completely exclude.

If there is any gain in excess of the eligible gain amount, it is taxed as a regular stock sale gain. A 20% maximum federal rate applies to excess gains that are recognized in 2016. You may also owe the 3.8% NIIT.

Tax-Free Rollovers of QSBS

There’s also a tax-free gain rollover break in addition to the qualified small business stock (QSBS) gain exclusion breaks explained. Under the rollover deal, the amount of QSBS gain that you must recognize for federal income tax purposes is limited to the excess of the QSBS sales proceeds over the amount that you reinvest to acquire other QSBS during a 60-day period. The reinvestment period begins on the date of the original sale.

It’s important to note that you must hold QSBS for over six months to qualify for the rollover deal. The rolled-over gain reduces the basis of the replacement QSBS.

Basically, the rollover deal allows you to sell your original QSBS without owing any federal income tax. With a rollover, you also won’t lose eligibility for the gain exclusion break when you eventually sell the replacement QSBS.

Business Structure Matters

Due to conventional tax-planning wisdom, you might believe that every start-up or closely held business should operate as a pass-through entity, such as an S corporation, partnership or limited liability company. However, if your business meets the definition of a QSBC, that assumption could be flawed, due to the gain exclusion breaks offered to QSBS owners. Consult Filler & Associates or your tax advisor for full details before starting up or investing in a new business in Maine.