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What Taxes are Taking a Bite Out of Your Returns, and Why?

By Ralph Turlington

tax-468440_1920Politicians love touting small businesses. They create jobs, add to the local economy, and develop new and innovative technologies. Both state and federal governments have attempted to create favorable tax treatment for small businesses and their investors to encourage growth.

How the Federal Government treats sales of qualified small business stock

The U.S. Congress passed Section 1045 in the Taxpayer Relief Act of 1997 to support small business creation. Section 1045 permits rollover treatment for qualified small business stock (QSBS)[1] sales occurring after mid-1997. Gains on the sale of QSBS held more than six months are not taxed when the sales proceeds are invested in another QSBS within 60 days. It should be noted that Section 1045 expires each year; so currently Section 1045 is not in effect. Historically, Congress has re-enacted Section 1045 at the end of each year and made it retroactive for the previous year.  It is likely this will happen again for the 2015 tax year.

Initially, Section 1045 applied to all individuals that pay taxes to the U.S. Federal Government. It was later expanded to allow rollover treatments to apply to any taxpayer including LLCs and partnerships, but excluding corporations.

The state rules may be different; take California as an example

These are the rules for all taxpayers to the U.S. Federal Government. However, states do not have to adopt the same regulations when taxing their own residents. One of the notable exceptions is California, which does not allow rollover treatment for sales of a QSBS. This means that even if you currently defer paying U.S. federal taxes from your original investment, you may still owe California taxes. In fact, you may actually owe a lot of California taxes.

So what can angel investors in California do to fully utilize Section 1045?  To quote an anonymous tax professional, “leave California.” In addition to denying California residents any state tax relief relating to Section 1045, California also denies favorable tax treatment to qualified dividends and long-term capital gains, both of which have lower tax rates for federal tax purposes. If leaving California is not in the cards for you, then be sure and keep detailed and accurate records of your basis in any stocks you own. When selling stock such as QSBS, investors should be mindful of state and federal tax treatments.

It is likely that California will eventually re-enact at least some of the tax benefits that Section 1045 provides – they have in the past. However, California will likely wait for the U.S. Congress to re-enact the provision before doing so.

Stay tuned!

For more information on the federal vs. California treatment of Section 1045, please see this document from the State of California Franchise Tax Board here. Information on QSBS sales is in the middle of page 9.

(Disclaimer: This article is meant to provide a simplified overview of a complex legal topic. It involves some interpretation and by no means should this material be considered legal advice.)

[1] QSBS, as defined in IRC Section 1202c:

  • Issued by a C corporation with no more than $50 million of gross assets at the time of issuance
  • At least 80% of its assets (by value) must be used in an active trade or business
  • Issued after August 10, 1993
  • Held by a non-corporate taxpayer
  • Acquired by the taxpayer on original issuance
  • Held for more than six months to be eligible for a tax-free rollover under Section 1045 and more than five years to qualify for gain exclusion (under Section 1202)
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