There are very few “free lunches” in the tax code. Qualified Small Business Stock (commonly referred to as “QSBS”) rules are one of the best giveaways in the tax code. Imagine selling $10,000,000 of stock at a gain and paying no tax on the profit on April 15th. That’s a $2,300,000 reduction in your tax bill! Want to learn more about this amazing section of the tax code? Let’s dive into the details.

What is Qualified Small Business Stock?

QSBS is governed by Section 1202 of the Internal Revenue Code and became law back in 1993. At the time of enactment, the exclusion was only at 50% of your capital gain and capital gains were 28%. Congress continued to lower the capital gains rate through the 90s & 00s but didn’t update Sec 1202. Capital gains were lowered to their current day rate of 15% in 2022. Consequently, the QSBS exclusion was only worth about 1% in terms of tax savings.

It wasn’t until 2009 that Congress decided to pay some attention to this provision of code. The 50% exclusion was raised to 75% in 2009 and temporarily increased in 2010 to 100%. The Path Act in 2015 made the 100% exclusion permanent.

The tax benefit is very generous. However, there are a number of restrictions that can prohibit you from taking advantage of the gain exclusion.

QSBS Requirements:

  • The issuer must be a C corporation in the U.S. (it can’t be an S corporation).
  • The corporation’s assets must be $50 million or less at all times after August 9, 1993 (or the period of the company’s existence) before and after the issuance of the stock.
  • The corporation must be an active business (not a holding company) at all times that the stock is held.
  • The corporation must be in a business other than one involving personal services; banking, insurance, financing, leasing or investing; farming; mining; or operating a hotel, motel or restaurant. 
  • Both the corporation and the shareholder must consent to provide certain documentation for the stock.
  • The stock must be acquired in exchange for money or property or as pay for services provided to the corporation. Someone who acquires QSBS from another person usually cannot take advantage of the tax break for gain on the sale of the stock.

When we talk about “stock” above, we generally mean voting or nonvoting common or preferred stock. Stock options and warrants aren’t generally considered “stock” here until they turn into shares. And the relatively new “simple agreement for future equity” or “SAFEs” may or may not qualify for the QSBS benefits. That’s because the IRS hasn’t provided clarification.

With Congress lowering the corporate tax rates from 35% to 21% in 2018 with the Tax Cut & Jobs Act, we’ve seen a resurgence in interest in the QSBS exclusion.

How Do You Take Advantage of QSBS?

Before you sell your stock, you’ll want to be certain that your company stock meets the guidelines above. Generally, we see the company contract with an accounting firm to audit their financial records and provide an in-depth report ensuring that all the rules have been met.

Once you’re sure the stock you own is QSBS, there are some limitations on the gain exclusion.

Step 1 – Determine Your Holding Period

You will need to determine the acquisition date when you received the stock. The time you’ve held the stock will determine the exclusion amount as follows:

  • Stock acquired after September 27, 2010: If it’s held for more than five years, there is no tax on the gain. It is free from income tax, alternative minimum tax and the 3.8% net investment income tax. If it’s held for more than one year but not more than five years, the gain is treated like any other capital gain taxed at up to 20%. If it’s held for one year or less, the gain is short-term capital gain that’s effectively taxed as ordinary income.
  • Stock acquired between February 18, 2009, and September 27, 2010: If it’s held for more than five years (which would be shares held now), then 75% of the gain is excludable from gross income. Also, 7% of the gain is subject to the alternative minimum tax.
  • Stock acquired before February 18, 2009: The exclusion of gain is limited to 50%, and 7% of the gain is subject to the alternative minimum tax.

Step 2 – Compute Your Gain Exclusion

After you’ve determined your holding period, the next step is to compute your gain exclusion. Your gain on the sale of stock is the proceeds of the sale less the purchase price of your stock. Your purchase price could be the cash paid for the shares or the value of the shares included in your income if shares were transferred in exchange for services. 

The maximum gain limitation is generally thought of as $10,000,000. However, Sec 1202(b) defines the gain exclusion as the higher of $10,000,000 (once per company) or 10 times the cost basis of your stock. While the $10,000,000 exclusion can only be used once for stock in the same company, there are instances where you can get a second gain exclusion with a properly timed sale.

This second gain exclusion will generally come into play when you have a higher than nominal cost basis in some of your shares and time your sales to happen in different tax years. While this fact pattern isn’t common, it could save you hundreds of thousands of tax dollars.

Summary

The Qualified Small Business Stock exclusion can be a powerful tax planning tool. We’ve seen clients save hundreds of thousands of dollars in taxes by ensuring that they have met the rules. If you have questions about QSBS, reach out to one of our tax experts for more details.

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