What is the Qualified Small Business (QSBS) Exclusion?

The QSBS Exclusion originally sprang from the Revenue Reconciliation Act of 1993, which aimed to address budget deficit issues and encourage investment in U.S. small businesses.

In pursuit of the latter objective, the act added Section 1202 to the tax code, establishing the rules, eligibility criteria, tax benefits, and requirements for the QSBS Exclusion.

However, to qualify for this benefit, specific criteria exist, including the five-year holding period and restrictions on the corporation’s assets and business operations.

The percentage exclusion depends on when the qualified small business stock was originally issued:

  • 50% exclusion: Stock issued from August 10, 1993 to February 17, 2009
  • 75% exclusion: Stock issued from February 18, 2009 to September 27, 2010
  • 100% exclusion: Stock issued after September 27, 2010

This means shareholders of the newest qualified small business stock can potentially eliminate all federal capital gains taxes on profits from the sale.

However, Section 1202 does cap the amount of gain exclusion at the greater of:

  • $10 million OR
  • 10 times the adjusted basis of the stock sold

The adjusted basis represents the shareholder’s capital investment in the stock, including the original purchase price plus contributions of cash, assets, or services to the company.

For example, if you invested $1 million originally for qualified small business stock and later contributed $500,000 of additional assets to the business, your adjusted basis would be $1.5 million. So your maximum exclusion would be $15 million under the 10 times basis rule since that exceeds the flat $10 million cap.

While the federal exclusion offers the most significant benefit, most states also conform to Section 1202. So, the overall capital gains tax savings can be dramatic for entrepreneurs and investors who plan smartly to qualify.

However, some key states, including California, New Jersey, and Pennsylvania, do not allow the exclusion. Understanding the specific treatment in your state is important.

What is the 80% rule for QSBS?

Among other requirements, which we’ll cover below, the “80% rule” stipulates that at least 80% of the fair market value of a corporation’s assets must be used in qualifying business activities, as opposed to passive investments or real estate.

Service businesses are also restricted, as are hospitality, banking, farming, natural resources extraction, and several other sectors, including any trade or business where the principal asset is the reputation or skill of one or more of its employees.

Restricted fields include:

  • Health
  • Law
  • Engineering
  • Architecture
  • Accounting
  • Actuarial Science
  • Performing Arts
  • Athletics
  • Financial Services
  • Brokerage Services
  • Consulting

The reason for this requirement is to ensure that the tax benefits of Section 1202 target businesses that are actively using their assets to generate income and contribute to economic growth.

If a corporation fails to meet this 80% rule, it may not qualify, and the shareholders may be unable to claim the tax exclusion benefits.

What are the eligibility requirements for the QSBS Exclusion?

Both corporations issuing the stock and shareholders receiving it must meet specific requirements for the QSBS Exclusion to apply — and they are very specific.

Failing to adhere to even one of these requirements could undermine the entire strategy.

Requirements for Corporations

Here are the criteria corporate stock issuers must satisfy:

  • Organized as a C Corporation in the U.S.: The company must be a C corporation organized and headquartered in the United States. Other entity structures like S corporations and LLCs do not qualify at the federal level.
  • Aggregate Gross Assets Under $50 Million: Immediately after the qualified stock issuance, the corporation’s aggregate gross assets cannot exceed $50 million. This includes cash plus the adjusted tax basis of assets on the company’s balance sheet.
  • 80% of Assets Used in Active Qualified Trade or Business: This is the “80% rule” mentioned above.
  • No Significant Redemptions Before Stock Issuance: The company cannot have redeemed or repurchased 5% or more of its stock’s aggregate value in the 2 years before the qualified stock issuance. This anti-abuse rule aims to prevent shareholders from pulling out equity tax-free and then reinvesting soon after to qualify for the exclusion.

Requirements for Shareholders

Shareholders wanting to claim the tax break also face obstacles. For example:

  • Directly Acquired Original Issuance Shares: Taxpayers can only exclude gains on a stock they directly acquired through an original issuance from the company to the shareholder. The tax code prevents buying the exclusion benefits second-hand from another shareholder. Some exceptions exist for inherited or gifted stock.
  • Held Shares Over 5 Years Before Sale: To qualify for tax-free gains, shareholders must hold the eligible small business stock for over five years before any sale or transfer. Carefully tracking holding periods and transitions between shareholders is crucial.
  • Minimal Redemptions in 2 Years Before and After Issuance: Neither shareholders nor related parties can have significant redemptions or repurchases of company stock for the two years before and after the qualified stock issuance. The IRS aims to prevent manipulation with this rule.

To qualify, corporations and shareholders must continually monitor eligibility and seek expert guidance. With thoughtful planning, however, substantial tax savings may await.

How do you maximize your QSBS Exclusion?

While the exclusion offers a straightforward benefit on the surface, you may be able to amplify or even multiply the advantages.

To fully leverage your QSBS, consider the following strategies:

  • Invest in Multiple Qualified Small Businesses: By diversifying your investments across different qualifying small businesses, you increase the likelihood of having a significant gain that could benefit from the QSBS exclusion.
  • Carefully Plan for the $10 Million Cap: The typical cap for the gain exclusion is $10 million. However, with careful planning, this cap could be effectively multiplied if the investment is made through multiple family members, each of whom may be entitled to their own $10 million exclusion.
  • Make Section 83(b) Elections: Stock options and restricted stock grants only start the QSBS holding clock when they vest and convert to actual shares. A Section 83(b) election treats restricted stock and stock purchased via early option exercise as outstanding from the grant date, thereby enabling you to hit the five-year mark sooner. The tradeoff is recognizing ordinary income on the stock’s value at vesting, but this cost is usually minimal compared to the later exclusion.
  • Roll Over QSBS Sale Proceeds Using Section 1045: If you want to sell QSBS before hitting the five-year mark, Section 1045 allows you to roll over the proceeds into a new QSBS within 60 days. By reinvesting wisely, you can defer gains until the replacement QSBS is sold after five years. This provides flexibility to profit from one investment while pursuing new QSBS opportunities.
  • Regularly Review the Eligibility: Given the complex requirements for QSBS and the severe consequences of non-compliance, regular review of the corporation’s ongoing eligibility is crucial. This can help ensure the corporation meets the 80% rule and other eligibility requirements.

Remember, the strategies to maximize the QSBS exclusion heavily rely on individual circumstances and tax law, so it’s crucial to consult with professional tax advisors…like us!

It can take some effort, but with such significant savings on the line, getting this right is worth it.

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