Proposed amendments to section 1202: Effect on federal tax liability
The real impact of a potential return to the 50% gain exclusion
TAX ALERT |
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.