What is Qualified Small Business Stock and Why Is It Important?
Shares of a “qualified small business” (as defined by the Internal Revenue Code) issued after August 10, 1993 are referred to as “qualified small business stock” or “QSBS”.
Provided certain requirements are met, the sale of QSBS receives favorable tax treatment. This is particularly important when shares have increased significantly in value (or, “appreciated”) and might otherwise be subject to capital gains tax.
Continue reading to learn more about qualified small businesses and qualified small business stocks: the types, advantages, and disadvantages.
Qualified Small Business Stock (QSBS) Acquired After 2010
Under current rules, for QSBS acquired after 2010, 100% of the gain realized on the sale of the QSBS is excluded from taxation, up to the greater of $10 million or 10X the seller’s aggregate adjusted tax basis. This is referred to as the “Section 1202 gain exclusion”. This is significant because it can result in substantial income and tax-savings for sellers.
Qualified Small Business Stock (QSBS) Acquired Before or During 2010
For QSBS acquired prior to 2010, sellers of QSBS receive only a 50% Section 1202 gain exclusion and for stock acquired during certain periods of 2009 and 2010, sellers of QSBS receive a 75% 1202 gain exclusion – and there is pending legislation that might change the rules yet again.
Things to Keep In Mind as a QSBS
While the advantages associated with QSBS sales may be substantial, there are a lot of things to be aware of when it comes to QSBS. First, only certain types of businesses may be considered “qualified small businesses” and therefore, only certain types of businesses can issue QSBS. Secondly, there are a number of additional requirements that must be met before the holder of QSBS can qualify for the Section 1202 gain exclusion. Finally, depending on the outcome of pending legislation, the degree to which QSBS receives favorable tax treatment may change.
What Is a Qualified Small Business?
What sorts of businesses can be “qualified small businesses” under the Internal Revenue Code? A limited number of businesses fall within the Internal Revenue Code definition of “qualified small business”. To be considered a qualified small business, ALL of the following must be true:
- The business is an active business (meaning that at least 80% of the business’s assets are actively used in the conduct of its ongoing trade)
- The business is a domestic business
- The business is a C Corporation (no other corporate form may be considered a “qualified small business”)
- The business must not have “aggregate gross assets” in excess of $50 million immediately before or after issuing QSBS (note that certain subsidiary assets may factor into that $50 million calculation)
- The business must be engaged in a “qualified trade or business” as defined by the Internal Revenue Code.
- The following are NOT qualified: health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services (including banking, insurance, financing, leasing, investing, etc.), brokerage services, farming, and hospitality (eg, hotel, motel, restaurant).
- This generally means only businesses engaged in certain technology, retail, wholesale, and manufacturing sectors are eligible to be considered “qualified small businesses”.
QSBS Seller Requirements for Section 1202 Gain Exclusion
What requirements must be met in order for the seller of QSBS to be eligible for the Section 1202 gain exclusion? In order to issue QSBS, the issuing business must meet ALL of the above qualifications; but, even if stock is properly considered QSBS, in order to take advantage of the Section 1202 gain exclusion, the seller must meet ALL of the following additional requirements:
- The seller is a taxpayer OTHER THAN a C Corporation (eg, an individual, partner in an LLC, S corp, etc)
- The seller acquired the QSBS at “original issue” (ie, directly from the issuing qualified small business itself)
- The seller acquired the QSBS in exchange for money or as compensation for services performed for the issuing business (ie, not in exchange for other stock)
- The seller must be the original owner of QSBS (subject to limited exceptions, such as for QSBS acquired by gift or inheritance)
- Prior to sale, the seller must have held the QSBS for at least 5 years (although there may be ways to navigate around this requirement using a technique called a 1045 rollover)
Pending Legislation May Change The Rules Applicable to QSBS
On September 13, 2021, draft legislation was issued that might decrease the amount of the 1202 gain exclusion applicable to certain taxpayers back to the 50% exclusion applicable prior to 2010. This may reduce the potential tax advantages associated with investing in a qualified small business. Moreover, the corporate tax rates will likely increase so an analysis should be done to see if this makes sense.
For those considering the sale of QSBS, there may be time to act soon to take advantage of current rules.
For those considering the advantages and disadvantages of various forms of entity formation, know that there may still be advantages to C corporations (over S corporations or LLCs or partnerships) even if the tax advantages of QSBS are diminished.
For more information, please contact our office at 714-525-2400.