Gain rollover. With limited exceptions, you can elect to “rollover” gain from the sale of QSBS sold by you, or by a partnership, mutual fund or “S corporation” (see “What is QSBS” below) in which you hold an interest. (Partnerships, mutual funds, S corporations, estates and trusts can also elect rollover treatment.)

In a rollover in which you are the seller of the QSBS, you can sell the QSBS without currently paying tax on the gain if you:

 (1) held the QSBS sold for more than six months; and

 (2) buy, within 60 days of the sale, other QSBS (replacement stock) at a total cost at least equal to the total amount you realized from the sale.

The rollover enables you to end or reduce your investment in the QSBS without currently paying tax on the gain. Also, because there is no rule requiring you to buy replacement QSBS in only one corporation, you can, in one or more rollovers, spread your risk among stocks in multiple small corporations.

Gain not currently taxed in a rollover (“unrecognized gain”) will be fully taxed on a sale of the replacement stock, if the replacement stock is not itself rolled over and the amount received from the sale of the replacement stock exceeds the “basis” of the replacement stock (that is, its cost reduced by the unrecognized gain).

However, if the later sale is at a price less than the basis, the unrecognized gain will be permanently excluded from your income.

Also, part of the unrecognized gain will be permanently excluded if the later sale itself qualifies for the partial exclusion from income discussed below.

Partial gain exclusion. A 50% permanent exclusion of gain from the sale or exchange of QSBS is available to the same types of taxpayers as those eligible for the gain rollover. (The exclusion is 60% for QSBS acquired after Dec. 21, 2000 and invested in certain corporations doing business in a few designated areas referred to as empowerment zones).

No election is required for the exclusion to apply.

However, you should be aware that the benefit from the exclusion is much smaller than it appears. This is so because of a rule that, generally, imposes tax at a rate of 28% on the 50% (or 40%) portion of long-term capital gain from the sale or exchange of QSBS that is not excluded from income.

Thus, the effective long-term capital gain rate for QSBS that qualifies for the 50% exclusion is, generally, 14% (28% × 50%), which is only 1% less than the 15% capital gains rate that, generally, would otherwise apply. Also, 7% of the excluded part of the gain can expose you to the alternative minimum tax (AMT), which may completely eliminate the benefit of the exclusion.

To qualify for the exclusion, you must hold the QSBS for more than 5 years before you sell or exchange it.

Thus, the amount of gain excludible in any tax year is limited to 50% (or 60%) of the greater of:

 (1) $10 million ($5 million for a married individual filing separately) reduced by the amount of gain taken into account in earlier years, or

 (2) 10 times the basis — excluding amounts added to the basis after the stock was issued — of the stock disposed of in the year. Both limits are applied on a per-taxpayer per-issuer basis.

For example, if a married couple filing jointly owns QSBS in 3 different corporations, they can together exclude at least $15 million of gain ($10 million of gain × 3 × 50%).

The inflexibility caused by the more-than-5-year holding period required for the exclusion may be reduced by the availability of the gain rollover discussed above.

Example. Mr. Smith, on Dec. 1, Year 1, buys QSBS in corporation A for $1 million, sells that QSBS after two years for $2 million, purchases $2 million of QSBS in corporation B during the 60-day rollover period and, on Dec. 2, Year 6, sells the B stock for $4 million (without buying replacement stock).

Even though Mr. Smith held neither the A nor B stock for more than 5 years, he satisfies the more-than-5-year holding period requirement and will have a total taxable gain of no more than $1.5 million.

What is QSBS. To be QSBS, stock must be issued after Aug. 10, 1993 and, with exceptions, must be stock you acquire when it is issued (directly or through an underwriter) in exchange for money, property (other than stock) or services (other than underwriting). Also, the stock must be stock in a corporation that:

(1) for substantially all the time that you hold the stock is not a mutual fund or other special type of corporation;

(2) at the time the stock is issued and for substantially all the time that you hold the stock, is a U.S. corporation and is not an S corporation (a corporation that, under subchapter S of the income tax provisions of the Internal Revenue Code, has elected to not be subject to the regular income tax on corporations);

(3) at all times after Aug. 10, 1993, and before the issuance of the stock, has gross assets that don't exceed $50,000,000 (taking into account predecessor and affiliated corporations);

(4) immediately after the stock is issued, has gross assets that don't exceed $50,000,000 (taking into account affiliated corporations);

(5) for substantially all the time that you hold the stock, uses — taking into account subsidiary corporations — more than 80% of its assets in the active conduct of a trade or business.

Some types of businesses (like farming), even if actively conducted, don't count toward satisfaction of this 80% “active business” test, and some investments in real estate, stocks or securities can cause an otherwise qualifying corporation to fail the 80% test.

As you can see, the rules for QSBS and its benefits are complicated (and some special pro-taxpayer rules not discussed above also may apply).