Own Qualified Small Business Stock (QSBS)? This Exclusion Could Yield Significant Tax Savings

From startups to shareholders, the opportunity to profit from a successful small business can be life-changing.

However, capital gains taxes on the entire amount recognized from the eventual sale of your valuable shares could cut deeply into your profits, taking the shine off your success.

Fortunately, savvy business owners, investors, and private equity groups know about an under-utilized tax code provision that seems almost too good to be true: IRC Section 1202 or the Qualified Small Business Stock Exclusion (QSBS).

This powerful tool enables shareholders to exclude some or potentially all capital gains from selling eligible small business stock from federal income taxes.

In the right circumstances, you could shield up to 100% of your taxable gain from the IRS, a whopping potential tax savings.

To take full advantage of Section 1202, it’s critical to understand the requirements and rules — not to mention whether or not you are even eligible for this exclusion.

In this article, we’ll explore the QSBS Exclusion in detail. Whether you already own small business stock or plan to in the future, read on to discover how this tax provision could put significant amounts of money back into your pocket.

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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Jeff Coyle, CPA

Jeff Coyle, CPA, Partner of Rosenberg Chesnov, has been with the firm since 2015. He joined the firm after 20 years of business and accounting experience where he learned the value of accurate reporting, using financial information as a basis for good business decisions and the importance of accounting for management.

He is a diligent financial professional, able to manage the details and turn them into relevant business leading information. He has a strong financial background in construction, technology, consulting services and risk management. He also knows what it takes to create organizations having built teams, grown companies and designed processes for financial analysis and reporting.

His business experience includes:

Creating and preparing financial reporting, budgeting and forecasting.
Planning and preparation of GAAP and other basis financial statements.
Providing insight on financial results and providing advice based on those results.

Jeff also has a long history of helping individuals manage their taxes and plan their finances including:

Income tax planning and strategy.
Filing quarterly and annual taxes.
Audit support.
General financial and planning advice.
Prior to joining the firm in 2015, Jeff was in the private sector where he held senior financial and management positions including Controller and Chief Financial Officer. He has experience across industries, including construction, technology and professional services which gives him a deep understanding of business.

Jeff graduated from Montclair State University, he is a CPA and member of the American Institute of Certified Public Accountants, New York State Society of Certified Public Accountants and New Jersey State Society of Public Accountants.

Jody H. Chesnov, CPA

Jody H. Chesnov, CPA, Managing Partner of Rosenberg Chesnov, has been with the firm since 2004.  After a career of public accounting and general management, Jody knows the value of good financials.  Clarity, decision making, and strategy all start with the facts – Jody has been revealing the facts and turning them into good business results for more than three decades.

He takes a pragmatic approach to accounting, finance and business. His work has supported many companies on their path to growth, including helping them find investors, manage scaling and overcome hurdles.  His experience and passion for business reach beyond accounting and he helps businesses focus on what the numbers mean organizationally, operationally and financially.

He has a particular expertise in early-stage growth companies.  His strengths lie in cutting through the noise to come up with useful, out of the box, solutions that support clients in building their businesses and realizing their larger visions.

Prior to joining the firm in 2004, Jody was in the private sector where he held senior financial and management positions including General Manager, Chief Financial Officer and Controller.  He has experience across industries, which gives him a deep understanding of business.

Jody graduated with a BBA in Accounting from Baruch College, he is a CPA and member of the American Institute of Certified Public Accountants and New York State Society of Certified Public Accountants.

In addition to delivering above and beyond accounting results, Jody is a member of the NYSCPA’s Emerging Tech Entrepreneurial Committee (ETEC), Private Equity and Venture Capital Committee and Family Office Committee.  

He is an angel investor through the Westchester Angels, and has served as an advisor for many startup companies and as a mentor through the Founders Institute.

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