Politicians 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) 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. This will likely happen again for the 2024 tax year.
Initially, Section 1045 applied to all individuals who 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.
Section 1045: 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 utilize Section 1045 fully?
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.
California does not conform to the qualified small business stock deferral and gains exclusion under IRC Section 1045 and IRC Section 1202.
For more information on the federal vs. state treatment of Section 1045, please see this document sourced from QSBS expert.
 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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This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
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