California Exclusion of 50% Gain from Sales of QSBS
Alan L. Olsen, CPA, MBA (tax)
Greenstein, Rogoff, Olsen & Co., LLP
The FTB issued Notice 2012-03 on December 21, 2012. The Notice states that the Court of Appeal's holding in Cutler v. Franchise Tax Board (2012) 208 Cal. App. 4th 1247, that the qualified small business stock exclusion and deferral statutes determined that the qualified small business stock statues--California Revenue and Taxation Code (CR&TC) Sections 18038.5 and 18152.5--are invalid and unenforceable. The FTB will individually notify taxpayers who reported a qualified small business stock exclusion or deferral for taxable years beginning on or after January 1, 2008 that because these provisions are invalid and unenforceable, Notices of Proposed Assessments will be issued denying the exclusion or deferral.
Based on the Notice, FTB will allow QSBS gain exclusion for taxable years beginning before January 1, 2008.
To encourage investment in new ventures, small businesses, and specialized small
business investment companies, Section 1202 of The Internal Revenue Code grants
relief to investors who risk their funds in these businesses. California modified
the 1202 rules to limit the exclusion only for those companies conducting a substantial
portion of business within California during each of the test years.
Noncorporate investors may exclude up to 50 percent of gain they realize on the
disposition of qualified small business stock issued after August 10, 1993 and held
more than five years. The amount of gain eligible for the 50 percent exclusion is
subject to per-issuer limits. The exclusion is available to taxpayers who own eligible
stock in a qualified corporation (hold the stock for more than five years), and
the corporation meets requirements that it actively conducts a qualified trade or
business and is under a maximum gross assets test.
The five year holding period requirement can be satisfied no earlier than August
12, 1998, since the exclusion can only apply to stock issued after August 10, 1993.
For gain on its stock to qualify for the exclusion, a corporation must be a C corporation
other than a
- A regulated investment company
- A real estate investment trust;
- A real estate mortgage investment conduit;
- A financial asset securitization investment trust;
- A cooperative; or
- A corporation electing the Puerto Rico and possessions tax credit.
Stock issued to a taxpayer cannot qualify -for the exclusion if the issuing corporation
purchases (directly or indirectly) any of its own stock from the taxpayer or persons
related to the taxpayer, with the four-year period beginning two years before the
issue date. A 'safe-harbor' de ' ' is amount can be redeemed without rendering the
stock ineligible for the exclusion. The aggregate amount paid for the stock by the
issuing corporation in such redemptions cannot exceed $I 0,000 or more than 2 percent
of the stock held by the taxpayer and all related persons.
Stock will also not qualify for the exclusion if the issuing corporation engages
in a 'significant redemption'. A redemption is significant if the corporation, within
a two year period beginning one year before the issuance of the stock, redeems stock
with an aggregate value exceeding 5 percent of the aggregate value of all the corporation
stock. A de minimis exception applies if either the aggregate amount paid for all
stock redeemed during the two year period does not exceed $10,000,000 or no more
than 2 percent of all outstanding stock.
Cal. Rev. & Tax. Cd. § 18152.5 Exclusion from gross
income of gain from sale or exchange of “qualified small business stock.”
Summary of Main Points in the Regulation §18152.5:
IRC 1202 allows the exclusion of the gain from the sale of QSBS under certain conditions.
California does not conform to Sec. 1202. California does, however, have similar
provisions for the exclusion of the gain from small business stock. (CR&TC §18152.5).
- CR&TC §18152.5(a) allows for the exclusion
of 50% of the gain from the sale or exchange QSBS held for more than five years.
- §18152.5(b) requires that aggregate amount of the eligible gain from dispositions
of stock issued by the corporation for the taxable year shall not exceed the greater
of either of the following:
(a) Ten million dollars ($10,000,000 MFJ) reduced by the aggregate
amount of eligible gain taken into account by the taxpayer under subdivision (a)
for prior taxable years and attributable to dispositions of stock issued by the
(b) Ten times the aggregate adjusted bases of qualified small business
stock issued by the corporation and disposed of by the taxpayer during the taxable
- CR&TC §18152.5(c)(1) defines “Qualified small
business stock” means any stock in C corporation, a qualified small business, which
is originally issued after August 10, 1993 if the stock is acquired by the taxpayer
at its original issue (directly or through an underwriter) in exchange for
money or other property (not including stock), or as compensation for services
provided to the corporation (other than services performed as an underwriter of
- CR&TC §18152.5(c)(2)(A) requires that the
corporation meet the active business requirements of §18152.5(e) for substantially
all of the taxpayer's holding period.
- §18152.5(e)(1)(A) requires that the corporation
use at least 80 percent (by value) of the assets of the corporation in the
active conduct of one or more qualified trades or businesses in California.
- §18152.5(e)(5)(B) requires that a corporation
shall be treated as failing to meet the requirements of QSBS for any period during
which more than 10 percent of the value of its assets (in excess of liabilities)
consists of stock or securities in other corporations which are not subsidiaries
of the corporation.
- §18152.5(e)(6) provides that for purpose of the
80% asset test, the following assets shall be treated as used in the active conduct
of a qualified trade or business: (A) Assets that are held as a part of the reasonably
required working capital needs of a qualified trade or business of the corporation;
and (B) Assets that are held for investment and are reasonably expected to be used
within two years to finance research and experimentation in a qualified
trade or business or increases in working capital needs of a qualified trade or
business. For periods after the corporation has been in existence at least two year,
in no event may more than 50% of the assets of the corporation qualify as
used in the active conduct of a qualified trade or business by reason of this paragraph.
- §18152.5(e)(7) requires that a corporation shall
not be treated as meeting the requirements of QSBS for any period during which more
than 10 percent of the total value of its assets consists of real property
that is not used in the active conduct of a qualified trade or business (not including
the ownership of, dealing in, or renting of, real property).
- §18152.5(e)(8) requires that rights to computer
software that produces active business computer software royalties (within the meaning
of Section 543(d)(1) of the Internal Revenue Code) shall be treated as an asset
used in the active conduct of a trade or business.
- §18152.5(e)(9) requires that no more than
20% of the company's payroll be attributable to employment outside of California.
- §18152.5(d)(1) requires that to be a "qualified
small business", a C corporation should meet the following requirements:
(A) The aggregate gross assets of the corporation (or any
predecessor thereof) at all times on or after July 1, 1993, and before the issuance
did not exceed fifty million dollars ($50,000,000).
(B) The aggregate gross assets of the corporation immediately after
the issuance (determined by taking into account amounts received in the issuance)
do not exceed fifty million dollars ($50,000,000).
(C) At least 80 percent of the corporation's payroll,
as measured by total dollar value, is attributable to employment located within
(D) The corporation agrees to submit those reports to the Franchise
Tax Board and to shareholders as the Franchise Tax Board may require to
carry out the purposes of this section (e.g., Form 3565).
- §18152.5(f) requires that if a corporation is
acquired solely through the conversion of other stock in the corporation
that is qualified small business stock in the hands of the taxpayer, both of the
following shall apply: (1) the stock so acquired shall be treated as qualified small
business stock in the hands of the taxpayer, and (2) the stock so acquired shall
be treated as having been held during the period during which the converted stock
- §18152.5(h) requires that in the case of a
transfer (e.g., by gift, at death, from a partnership to a partner), the transferee
shall be treated as (i) Having acquired the stock in the same manner
as the transferor; and (ii) Having held the stock during any continuous
period immediately preceding the transfer during which it was held (or treated as
held under this subdivision) by the transferor.