Qualified Small Business Stock

What is Qualified Small Business Stock?

Qualified Small Business Stock (QSBS) may also be referred to as “1202  Stock” after the section of the Tax Code addressing this topic.

Qualified Small Business Stock isn’t an election; if you meet the requirements, it is QSBS!

Key Benefit: Some or all the gain is excluded when you sell your business.

There are two main calculations for the gain exclusion. While the nuances of this are beyond the scope of this blog, to keep this simple, the maximum gain to exclude ranges between $10M – $500M. A primary factor in the calculation is the adjusted basis of your QSBS. The limits are per taxpayer and per business and are NOT mutually exclusive.

  • $10M is a cumulative lifetime amount, per issuer.
  • 10x the adjusted basis of the QSBS stock owned by the taxpayer sold during the year (i.e., you can use this calc more than once).

Let’s review the essential qualifications for this capital gain tax exclusion.

Entity Type

To qualify, the company must:

  • Be US-based.
  • Be a C corporation.
  • Remain a C corporation for substantially all the shareholders’ holding period.

Types of Stock

Most kinds of stock qualify, but options, warrants, and phantom stock don’t apply.

Anti-Churning Rule #1 (applicable at the business level)

The Corporation can’t redeem stock during a two-year blackout period, which begins one year before acquiring the Qualified Small Business Stock.

Anti-Churning Rule #2 (appliable at the shareholder level)

There’s a four-year blackout period beginning two years prior to the acquisition.

Entity Size

The business valuation prior to the issuance of QSBS must be $50M; this is the total asset value, including assets of a 50% or greater parent and/or subsidiary.

Also, the total assets immediately after issuance of QSBS must be less than $50M.

The calculation excludes certain assets that exceed specified thresholds when determining the total asset value.

Entity Activities

The Corporation must be a “qualified” trade or business (several professional service organizations are excluded, similar to the QBI tax deduction).

Stock Acquisition

The stockholder must receive the stock directly from the C corporation and not purchase it from another shareholder.

Also, the stockholder must exchange the QSBS for cash, property, or services rendered. If the latter, the stock must be 100% vested, or an 83(b) election is made.

Eligible Shareholders

A shareholder does not need to be a natural person but cannot be a C Corporation.

Required Holding Period

There is a five-year holding period starting with the date of acquisition; no short positions are allowed!

Original Owner Requirement

The owner must also generally be the seller, although limitations apply:

  • Gifted during the owner’s lifetime.
  • Transferred upon owner’s death.
  • Distribution in kind by a partnership to a partner.

Stock Sale Requirement

The sale of the stock must be a liquidating distribution or redemption.

Strategies to assist with a shortfall related to the five-year holding period

  • Sign the agreement to sell today with a deferred close date.
  • Allow the buyer to manage the business today and extend the close date.
  • Stock swap:
    • QSBS for QSBS – the five-year clock continues to tick, or
    • QSBS for non-QSBS stock – the excludable gain capped as of the date of the swap.
    • A 1045 rollover is similar to an IRA rollover in that there’s a 60-day limit to reinvest the proceeds into another QSBS. The stockholder must elect this on their tax return. Additionally, the stockholder must maintain the new QSBS for at least six months.
    • A 1045 rollover via an installment sale – this one is harder!
      • If you want to reinvest your proceeds, you must invest the entire amount even though it’s not all received upfront, which can be challenging.
    • Create a new C corporation that will begin operations as a QSBS.

Strategies to maximize the number of capital gain exclusions

  • Gift shares to others – recipients receive their $10M lifetime gain exclusion, also referred to as the “Genesis Strategy.”
    • Gifts to a spouse are a gray area – likely no additional exclusion amount.
  • If pursued, complete gifts well in advance of the sale to avoid potential assignment of income issues.
  • With this strategy:
    • The owner’s basis carries over to the gift recipient – this is a WIN!
    • The owner’s holding period carries over to the gift recipient – this is a WIN!
    • The owner’s gain limits do not carry over as each taxpayer receives a gain limit – this is a WIN!
  • Ensure the business valuation is tight and defensible to see if a gift return is necessary.

Interested in Supersizing your gain exclusion?

  • Use the packing strategy: fund the company with more before the sale to increase the adjusted basis of our founder’s tranche.
  • The result? Even though the addition of capital doesn’t meet the five-year holding requirement, your basis increases, which is what’s utilized in the 10x formula.
  • If you have multiple tranches of Qualified Small Business Stock with different basis amounts, selling low-basis QSBS first and then high-basis QSBS in a subsequent year may be advantageous.

A handful of states don’t follow the Federal tax policy on QSBS. Keep this in mind!

This is a complicated topic! If this concept applies to you, contact us to discuss it further.

Please consult with your financial advisor and/or tax professional to determine the suitability of these strategies. All views, expressions, and opinions in this communication are subject to change. This communication is not an offer or solicitation to buy, hold or sell any financial instrument or investment advisory services.