Qualified Small Business Stock Loophole

Gains on investments in Qualified Small Business Stock (QSBS) may be tax free if they meet the requirements of IRC Section 1202. Following are the major requirements:

  1. The stock must be owned in a domestic C corporation. S corporations and LLCs are not applicable for this benefit
  2. The maximum amount of assets at the time the stock was issued (and immediately afterwards) cannot exceed $50 million. Note that this refers to assets, not capital. For example if the corporation has $60 million in assets and $58 million in liabilities with a $2 million capital, it will not qualify
  3. The stock must be acquired at its original issue, either directly from the corporation or through an underwriter
  4. During the period of stock ownership at least 80% of the value of the corporation’s assets must be employed in the active conduct of a qualified business or businesses. Qualified businesses include those engaged in manufacturing, distribution and technology development. They do not include companies engaged in professional services, banking, brokerage or insurance activities, farming, a hotel, motel or restaurant
  5. The stock when disposed of must have been held at least five years
  6. The maximum gain in any one investment cannot exceed the greater of $10 million or 10 times the investor’s original basis
  7. Stock acquired after September 28, 2010 is 100% excluded. Stock acquired before then will have a limited exclusion
  8. The gain excluded from taxation is not subject to the 3.8% net investment income tax (NIIT)
  9. The 100% excluded portion is not an Alternative Minimum Tax (AMT) preference item but for stock acquired on or before September 28, 2010, 7% of the excluded gains are an AMT preference item
  10. The capital gains tax on income that is not excluded is 28% regardless of the taxpayer’s regular capital gains rate, plus the 3.8% NIIT if applicable
  11. To the extent there is an acquisition of the corporation and stock in the acquiring corporation is distributed, or if there is a Section 1045 transaction, the exclusion may still be able to be claimed – but check first with your tax advisor, as you should check everything beforehand with your advisor
  12. These rules apply to federal taxation and not state treatment. Each state has their separate rules that need to be examined

To make sure there will be no problem in claiming the exclusion, you should be able to fully document your purchases and the corporation’s qualification.

These rules seem complicated and they are, but they present a great opportunity if you start or invest in a company that qualifies. If there is a large gain on a future disposal of the corporate stock, it will be well worth the effort. To assure you receive the benefit you should have every one of these rules vetted beforehand by a knowledgeable tax advisor.

Assistance for this blog was provided by Brian Lovett, CPA, partner at WithumSmith+Brown, PC.

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