Turning startup profits into 100% tax-free gains.

(My apologies for the technical nature of this article. Perhaps it is best to just print it out and give it to the accountant or lawyer. However, it could be worth a great deal of money and there are a number of ways to really mess it up. MK)<p>Venture capitalists and private equity groups are reportedly taking an interest in structuring startups to qualify under the qualified small business stock (QSBS) provisions of Code Sec. 1202. It's not hard to see why — this often-overlooked Code provision can turn much or all of the profit on a successful investment in a startup into tax-free gain. But time may be of the essence: Under current law, the 100% exclusion won't apply for QSBS acquired after 2011. This Practice Alert provides an overview of the principal rules and opportunities.<p>Overview. Noncorporate taxpayers may exclude from gross income 100% of any gain realized on the sale or exchange of QSBS held for more than five years if the QSBS is acquired after Sept. 27, 2010 and before Jan. 1, 2012. The exclusion is 75% of gain realized on the sale or exchange of QSBS acquired after Feb. 17, 2009 and before Sept. 28, 2010, and 50% of gain realized on the sale or exchange of QSBS acquired either before Feb. 18, 2009, or after Dec. 31, 2011 (but 60% instead of 50% for certain gain attributable to QSBS in a qualified business entity). Excluded gain is subject to a cumulative and annual dollar limitation. (Code Sec. 1202(a)(4), Code Sec. 1202(b)(1), Code Sec. 1202(b)(2))<p>Additionally, the alternative minimum tax (AMT) preference for a portion of gain from the sale or exchange of QSBS that is excluded from gross income for regular tax purposes under Code Sec. 1202 doesn't apply to QSBS acquired after Sept. 27, 2010 and before Jan. 1, 2012. (Code Sec. 1202(a)(4)(C))<p>A noncorporate taxpayer's net capital gain that is adjusted net capital gain is taxed at a maximum rate of 15%. If the adjusted net capital gain would otherwise be taxed at a rate below 25% if it were ordinary income, it is taxed at a zero percent rate. (Code Sec. 1(h)(1)(B), Code Sec. 1(h)(1)(C)) Under current law, these rates are in effect through 2012. Net capital gain attributable to section 1202 gain (as well as collectibles gain) is taxed at a maximum rate of 28%. (Code Sec. 1(h)(1)(E), Code Sec. 1(h)(4)) Section 1202 gain is the excess of (1) the gain that would be excluded from gross income on the sale of certain QSBS under Code Sec. 1202, if the percentage limitations of Code Sec. 1202(a) didn't apply, over (2) the gain actually excluded under Code Sec. 1202. (Code Sec. 1(h)(7))<p>Qualifying as QSBS. Stock qualifies as QSBS only if it meets all of the following tests. (Code Sec. 1202(c), Code Sec. 1202(d))<p>(1) It must be stock in a C corporation (that is, not S corporation stock) originally issued after Aug. 10, '93.<p>(2) As of the date the stock was issued, the corporation was a domestic C corporation with total gross assets of $50 million or less (a) at all times after Aug. 9, '93, and before the stock was issued, and (b) immediately after the stock was issued. Gross assets include those of any predecessor of the corporation, and all corporations that are members of the same parent-subsidiary controlled group are treated as one corporation.<p><pre><code> Observation: The company must be relatively small when it begins life but if all the conditions are met, the Code Sec. 1202 exclusion is available no matter how large it grows. </code></pre> (3) In general, the taxpayer must have acquired the stock at its original issue (either directly or through an underwriter), either in exchange for money or other property or as pay for services (other than as an underwriter) to the corporation.<p>(4) During substantially all the time the taxpayer held the stock:<p>· The corporation was a C corporation;<p>· At least 80% of the value of the corporation's assets were used in the active conduct ...