When you are investing in or building a business, it is important to think about how your business is structured. You should think about the goal of your business. How big do you envision it getting? How many founders or partners do you intend to have? Are you planning for an exit or to create a sustainable business for your family?
All of these questions can dictate the best way to establish the entity structure of your business and who you want to be involved. These decisions lead to financial planning strategies, one of which is utilizing qualified small business stock. This tool is relevant for owners and investors. It can help you save a bundle of money in taxes if your business qualifies.
What is a Qualified Small Business Stock?
The IRS defines qualified small business stock (aka QSBS) per sec. 1202 of the Internal Revenue Code and IRS pub 550:
“(1) In general Except as otherwise provided in this section, the term “qualified small business stock'” means any stock in a C corporation which is originally issued after the date of the enactment of the Revenue Reconciliation Act of 1993, if – (A) as of the date of issuance, such corporation is a qualified small business, and (B) except as provided in subsections (f) and (h), such stock is acquired by the taxpayer at its original issue (directly or through an underwriter) – (i) in exchange for money or other property (not including stock), or (ii) as compensation for services provided to such corporation (other than services performed as an underwriter of such stock).”
(d) Qualified small business
For purposes of this section –
(1) In general, the term “qualified small business” means any domestic corporation which is a C corporation if –
(A) the aggregate gross assets of such corporation (or any predecessor thereof) at all times on or after the date of the enactment of the Revenue Reconciliation Act of 1993 and before the issuance did not exceed $50,000,000,
(B) the aggregate gross assets of such corporation immediately after the issuance (determined by taking into account amounts received in the issuance) do not exceed $50,000,000, and
(C) such corporation agrees to submit such reports to the Secretary and to shareholders as the Secretary may require to carry out the purposes of this section.
I.R.C. § 1202(b)(1) In General – If the taxpayer has eligible gain for the taxable year from 1 or more dispositions of stock issued by any corporation, the aggregate amount of such gain from dispositions of stock issued by such corporation which may be taken into account under subsection (a) for the taxable year shall not exceed the greater of —
I.R.C. § 1202(b)(1)(A) – $10,000,000 reduced by the aggregate amount of eligible gain taken into account by the taxpayer under subsection (a) for prior taxable years and attributable to dispositions of stock issued by such corporation, or
I.R.C. § 1202(b)(1)(B) – 10 times the aggregate adjusted bases of qualified small business stock issued by such corporation and disposed of by the taxpayer during the taxable year.
In simple terms, it is basically stock in a C corporation issued after 1993 that has never had gross assets that exceed $50 million dollars.
The Benefits of Qualified Small Business Stock:
Having ownership in QSBS can be beneficial due to the tax benefits. When you sell QSBS that has been held for 5 years or longer, you can exclude up to $10 million or 10x your basis, whichever is greater. The date of acquisition will dictate the amount you can exclude.
Basically, it works as follows:
- August 10th, 1993 through 2008 = 50% will be excluded from income
- February 17th, 2009 through September 27th, 2010 = 75% exclusion
- After September 27th, 2010 = 100% exclusion
Requirements for Qualified Small Business Stock
Including the points mentioned above, there are additional requirements that the corporation must meet in order to be considered QSBS per the Internal Revenue Code such as:
- Acquiring the stock at its original issue directly, or through an underwriter, in exchange for money or services.
- The corporation must have met the active business test defined and have been a C-corp the whole time you held the stock.
- 2 years before and 2 year after the stock was issued you, or a related party, cannot have sold more than a de minimis amount back to the corporation.
- 1 year before and 1 year after the stock was issued the corporation cannot have bought more than 5% of the total value of all its stock from anyone.
The active business test rules state that 80% of the corporation’s assets were used in a qualified trade or business. The rule specifically excludes the following types of trades or businesses:
- Service based firms in fields of health, law, engineering, accounting, architecture, consulting, athletics, financial services, or brokerage services.
- One whose principal asset is the reputation of skill of one or more employees.
- Any banking, insurance, financing, leasing, investing, or similar business.
- Any farming business
- Any business involved in the production or extraction of products for which percentage depletion can be claimed.
- Any business operating a hotel, motel, restaurant, or similar business
It also excludes the following corporations:
- A Domestic International Sales Corporation (DISC) or a former DISC;
- A corporation that has made, or whose subsidiary has made, an election under section 936 of the Internal Revenue Code
- A regulated investment company;
- A REIT;
- A REMIC;
- Certain financial asset securitization investment trusts (FASITs); or
- A cooperative
Example of Qualified Small Business Stock
This can be extremely useful if you are a shareholder in a corporation you have in your portfolio or are a founder of a company for example. You invest early on or throughout your career. Then at a later date, the company is sold for a much higher valuation than your initial investment.
Let’s say your original investment is $150,000 made in 2011 and then the company sells and you receive $8,000,000 in 2018. You’d have $7,850,000 in capital gains.
These would qualify as QSBS, and therefore would be eligible for partial or complete exclusion of the gain. In this simple example, the $7,850,000 would be excluded from taxation.
Imagine excluding $10,000,000 from taxes. This includes potentially all the taxes – Federal, state, AMT, cap gains, FICA, and NIIT. That is some serious savings right there.
Of course, there are countless exclusions and requirements that must be met, from how you purchased the stock and what type of business the company is. I would recommend always consulting a professional such as a CPA or attorney to ensure everything is in good order. As you can see from the requirements above, it can get complicated.
Pros and Cons of Qualified Small Business Stock
Obviously, the huge pro here is that your QSBS can potentially be excluded from taxation. This can save you tons of money.
If you have gains that exceed $10,000,000 then the remainder is subject to capital gains tax at 28%. This is still preferential to the ordinary income tax rates which would be at 37%.
I would say the major con is the complexity of the matter and ensuring that everything is met from a compliance perspective. Typically, if you are in this situation you are selling a closely held business to a much larger company.
This will involve a lot of time, money, and stress to make sure all parties involved are satisfied. That said, the fruits of your labor can be well worth it and provide wealth for generations to come.
Is A Qualified Small Business Stock Right For Your Business?
Keeping QSBS rules in mind can be helpful for planning purposes when you’re establishing your business or thinking about an exit strategy down the line. It is important to consider all the rules and regulations and how they apply to your business.
If you are not a C-corp but have been considering it, doing the appropriate research to understand the tax implications and costs of converting your entity structure would be the prudent thing to do.
If you’d like an objective second opinion about your finances, please contact Michael Shea, a CERTIFIED FINANCIAL PLANNER™ and owner of True Equity Wealth Management LLC. Email him at [email protected] or fill out a contact form.
This blog is provided for informational purposes only. Such views are subject to change at any point without notice. The information in the blog should not be considered investment or tax advice or a recommendation to buy or sell any types of securities. Some of our blogs or information therein have been obtained from third party sources believed to be reliable but such information is not guaranteed. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor’s financial situation or risk tolerance. No reliance should be placed on, and no guarantee should be assumed from, any such statements or forecasts when making any investment decision.