The real impact of a potential return to the 50% gain exclusion
TAX ALERT |
Authored by RSM US LLP
The latest version of the Build Back Better Act (BBB Act) curtails a taxpayer’s ability to exclude gain from the sale of qualified small business stock (QSBS) under section 1202.1 Specifically, certain higher-income taxpayers would only be able to exclude 50% of their gain from the sale or exchange of QSBS.2 Due to this proposal, it is essential to understand how this change to section 1202 could impact the effective rate of a taxpayer that disposes of QSBS.
Removing the 100% gain exclusion: The effect on federal tax liability
The current version of the BBB Act would eliminate the special 100% exclusion rate for gains realized from QSBS for taxpayers with an adjusted gross income (AGI) in excess of $400,000. As a result, only the baseline 50% exclusion would remain available to taxpayers whose AGI exceeds $400,000.3 This amendment to section 1202 would apply to a sale or exchange of QSBS occurring after Sept. 13, 2021, subject to a binding commitment exception.4 It is unclear whether upon final passage the effective date would be moved up or continue to be retroactive to Sept. 13, 2021.
Understanding the tax impact of the proposed amendment to section 1202 is more complicated than cutting the would-be tax savings available under the 100% gain exclusion in half. Taxpayers must be aware of several ways the Code imposes tax on section 1202 gain not excluded from gross income. Consider a simplified example.
Example – Individual A realizes $9 million of gain from the sale of QSBS to an unrelated third party. Assume that the BBB Act amended section 1202 as described above, the sale occurred after the effective date of the amendment, there was $0 basis in the QSBS, and no other amount was includible in Individual A’s gross income. Further assume that Individual A’s capital gains rate on non-QSBS stock is 20% and that they are married and filing a joint return. Individual A wants to determine their actual effective tax rate on the QSBS gain. Individual A would also like to compare that to what their effective tax rate would be had they realized $9 million of gain on non-QSBS stock.
Under the most recent proposal, individual A would exclude $4.5 million ($9 million * 50%) of the gain from gross income. The remaining $4.5 million of gain would be included in gross income. How is this amount taxed for U.S. federal income tax (federal tax) purposes?
- Capital gains tax – Individual A would be subject to $1,260,000 of capital gains tax ($4.5 million * 28%) under section 1(h)(4) with respect to their includible gain. Includible gain on QSBS that would otherwise be excluded from gross income had the 100% gain exclusion been available is taxed at a special 28% capital gains rate.5 Notably, Individual A’s 28% rate is higher than the 20% rate Individual would pay on capital gain from non-QSBS stock.
- Net investment tax – Individual A would be subject to $161,500 of net investment income tax under section 1411 with respect to their includible gain. Includible gain on QSBS, like other forms of investment income, can be subject to a 3.8% net investment income tax.6 In this case, the 3.8% tax would be imposed on $4.25 million, which is the amount by which the includible gain of $4.5 million exceeds a threshold amount of $250,000.7
- Alternative minimum tax – Individual A would be subject to $62,650 of alternative minimum tax (AMT) under section 55. A non-corporate taxpayer’s AMT is equal to the excess (if any) of their tentative minimum tax over their regular tax liability. Individual A’s tentative minimum tax is $1,322,650,8 and their regular tax is $1,260,000.9 Significantly, Individual A is subject to the AMT because the basis for calculating tentative minimum tax includes 7% of Individual A’s excluded QSBS gain (i.e., $315,000, equal to $4.5 million * 7%). Had Individual A sold non-QSBS stock, the $9 million of gain would not be subject to the AMT.10
In total, Individual A likely would be subject to $1,484,150 of federal tax on the sale of its QSBS, and the effective tax rate on the $9 million of gain realized would be approximately 16.49%. By way of comparison, Individual A likely would be subject to $2,132,500 of federal tax had they sold non-QSBS, and the effective tax rate on the $9 million of gain would instead be approximately 23.69%.11
The BBB Act would also add section 1A to the Code, which imposes an additional 5% tax to a taxpayer’s modified gross income in excess of $10 million, and an additional 3% on a taxpayer’s modified gross income in excess of $25 million.12 If Individual A exceeded those thresholds, these surcharges would be imposed on the gain, increasing Individual A’s effective tax rate. Even though the imposition of these surcharges would increase a taxpayer’s effective tax rate, they could heighten the relative impact of excluding 50% of QSBS gain.
The BBB Act’s amendment to section 1202 would eliminate the beneficial 100% gain exclusion under section 1202 for certain higher income taxpayers, leaving only the baseline 50% exclusion available to taxpayers whose AGI exceeds $400,000. As illustrated above, taxpayers cannot assume that they will obtain half of the tax savings that would otherwise be available under the current 100% gain exclusion. Taxpayers should consult their advisors regarding the effect of the proposed amendment to section 1202 on their federal tax and effective rate.13
1All references herein to “section,” or “Code” or “IRC” refer to the Internal Revenue Code of 1986, as amended, and all references to “Reg. section” are to the regulations issued thereunder.
2See section 138149(a) of H.R. 5376 (Nov. 3, 2021). As of the date of this alert, this legislation passed the United States (U.S.) House of representatives but not the U.S. Senate.
4Section 138149(b) and (c), H.R. 5376. Specifically, the amendment would not apply to a sale or exchange of QSBS if it was made pursuant to a written binding contract in effect on Sept. 13, 2021 and not subsequently modified in any material respect.
5Section 1(h)(4), (7).
7Under section 1411(a), the 3.8% tax is imposed on the lesser of (a) net investment income or (b) the excess of modified adjusted gross income over the threshold amount. For taxpayers that are married and filing jointly, the threshold amount is $250,000. See section 1411(b)(1).
8The tentative minimum tax is imposed on Individual A’s taxable excess of $4,736,250, which equals the taxable income of $4.5 million, plus $315,000 (i.e., 7% of excluded QSBS gain) under section 57(a)(7), less a $78,750 exemption amount for married taxpayers filing jointly. Next, a tax rate of 26% is imposed on the first $175,000 of taxable excess and tax rate of 28% on the remainder to reach the tentative minimum tax of $1,322,650. See section 55(b)(1) and (2).
9For purposes of the AMT, ‘regular tax’ does not include the 3.8% tax imposed under section 1411(a). See section 55(c)(1).
10In essence, Individual A’s tentative minimum tax would not exceed its regular tax liability because (a) their basis for calculating the tentative minimum tax would not include an add-back for excluded QSBS gain and (b) the tax rate imposed on the taxable excess would not exceed 20%. See section 55(b)(3).
11Under this alternative, Individual A likely would be subject to capital gains tax of $1.8 million ($9 million * 20%), a net investment income tax of $332,500 [($9 million – $250,000) * 3.8%], and $0 AMT.
12Section 138203, H.R. 5376.
13The simplified example in this alert is intended only as a basic illustration of the potential effect of the proposed amendments to section 1202 in the BBB Act. Each taxpayer’s calculation will vary depending upon their situation.
This article was written by Patrick Phillips, Eric Brauer and originally appeared on 2021-12-09.
2021 RSM US LLP. All rights reserved.
The information contained herein is general in nature and based on authorities that are subject to change. RSM US LLP guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. RSM US LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.
RSM US Alliance provides its members with access to resources of RSM US LLP. RSM US Alliance member firms are separate and independent businesses and legal entities that are responsible for their own acts and omissions, and each is separate and independent from RSM US LLP. RSM US LLP is the U.S. member firm of RSM International, a global network of independent audit, tax, and consulting firms. Members of RSM US Alliance have access to RSM International resources through RSM US LLP but are not member firms of RSM International. Visit rsmus.com/about us for more information regarding RSM US LLP and RSM International. The RSM logo is used under license by RSM US LLP. RSM US Alliance products and services are proprietary to RSM US LLP.
LaPorte is a proud member of the RSM US Alliance, a premier affiliation of independent accounting and consulting firms in the United States. RSM US Alliance provides our firm with access to resources of RSM US LLP, the leading provider of audit, tax and consulting services focused on the middle market. RSM US LLP is a licensed CPA firm and the U.S. member of RSM International, a global network of independent audit, tax and consulting firms with more than 43,000 people in over 120 countries.
Our membership in RSM US Alliance has elevated our capabilities in the marketplace, helping to differentiate our firm from the competition while allowing us to maintain our independence and entrepreneurial culture. We have access to a valuable peer network of like-sized firms as well as a broad range of tools, expertise, and technical resources.
For more information on how LaPorte can assist you, please call 713.548.2034.