How To Receive A Qualified Small Business Stock Tax Exclusion On A Secondary Sale Of Stock

The qualified small business stock (QSBS) exclusion generally provides for a full or partial exclusion of capital gain realized on the sale of QSBS. If the requirements are met, then taxpayers can exclude from gross income capital gain in an amount equal to the greater of (i) $10 million or (ii) an annual exclusion of 10 times their basis in the stock sold (for an exclusion amount up to $500 million). These limitations apply on a per-company and per-taxpayer basis, while there are many planning opportunities available to taxpayers, there are also many requirements that must be met in order to qualify for an exclusion under section 1202.

Primary and Secondary Sales of Stock

Raising capital is a normal part of the lifecycle of a start-up business. In the simplest case, a company raises equity capital by issuing common stock or preferred stock directly to investors. This is sometimes called a “primary” or “original” issuance of stock. While most companies use the funds received to accelerate their growth, sometimes they use part of the funds to redeem stock from existing shareholders. For example, a company may issue convertible preferred stock to investors and redeem common stock from existing shareholders/founders. This not only provides liquidity to existing shareholders (who hold non-publicly traded stock), but it also allows them to diversify their holdings before an exit via sale of the company or initial public offering (IPO). This structure also works well for existing shareholders because they have an opportunity to obtain a QSBS exclusion.

Another popular way for companies to provide liquidity and diversification for its existing shareholders is to allow them to engage in secondary sales of stock to investors in conjunction with the company’s primary issuance of stock. In secondary sales, investors purchase stock from existing shareholders rather than from the company itself, so the new funds flow directly to the shareholders, rather than to the company and then from the company to the existing shareholders in a redemption transaction. While the form of these two transactions is different, they both achieve an economically-similar result vis-à-vis the selling shareholders (and the tax issues discussed in this article apply to both forms of the transaction).

This article was originally published by Daniel Mayo in Forbes on January 29, 2022. Click here to continue reading the full article in Forbes.

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