The ability to exclude capital gain on the sale of qualified small business stock (QSBS) is one of the most powerful and exciting tax opportunities for business owners. It allows individuals to exclude from gross income the greater of $10 million or 10 times their initial investment in their company, with the potential to exclude up to $500 million of gain.
Most business owners are amazed to learn how much tax they can save with this provision. They think it is too good to be true. It’s not.
The purpose of the exclusion in section 1202, when it was enacted in 1993, was to encourage equity investment in small businesses, and that is exactly what it has done. It started out as a 50% exclusion, and then over time it was gradually increased to 75%, and then to 100% for QSBS acquired after September 27, 2010.
Currently, Congress is considering eliminating the 75% and 100% exclusion percentages for taxpayers making at least $400,000 per year. This is one of the proposals included in the recent iteration of the much-debated reconciliation bill.
The majority of taxpayers that take advantage of this provision are in the technology industry, mainly because of the potential for rapid and dramatic stock price appreciation in that sector, but it applies with equal force to manufacturing and other industries.
There are also numerous planning strategies that can be employed to multiply and expand the $10 million and 10-times-basis rules above. These strategies are sometimes referred to as stacking and packing, and they should not be overlooked.
This article summarizes the requirements to qualify for a gain exclusion under section 1202 and focuses on the latest developments from the IRS and from Congress.
Overview of QSBS
There are requirements that apply to the company (i.e., the issuer of QSBS), and there are requirements that apply to the individual shareholders (i.e., the taxpayers excluding gain on the sale of QSBS). Let’s start with the issuer requirements.
The company must be a domestic C corporation when it issues the QSBS and when the taxpayer/shareholder sells the QSBS. This means that the company cannot be a non-U.S. company, an S corporation (which is a pass-through entity similar to a partnership), and it cannot be a mutual fund, real estate investment trust (REIT), or certain other specified entities.
The company must be engaged in a qualified trade or business (QTB) during “substantially all” (likely somewhere between 70% and 90%) of the taxpayer’s holding period in the stock. A QTB is any trade or business other than certain excluded businesses.Excluded businesses include:
- any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees;
- any banking, insurance, financing, leasing, investing, or similar business;
- any farming business (including the business of raising or harvesting trees);
- any business involving the production or extraction of products of a character with respect to which a deduction is allowable under section 613 or 613A; and
- any business of operating a hotel, motel, restaurant, or similar business.
The company also must use at least 80% of the value of its assets in the active conduct of a QTB. This requirement generally does not pose a problem for companies unless they have excess working capital or they acquire a “bad” business like an insurance company or brokerage. In that case, the company will need to track the values of its “good” and “bad” businesses to ensure that at least 80% of its assets are used in the “good” business. This is not always easy to do.
The company’s gross assets at all times before issuance of the relevant QSBS, and “immediately after” the issuance of QSBS, must not exceed $50 million. There a lot of nuances to this calculation.
Last, the company must not have engaged in certain redemption transactions from its shareholders, it must not hold more than 10% of the value of its assets in portfolio stock (generally 50%-or-less owned subsidiaries), and it must not hold more than 10% of the value of its assets in real estate not used in its business.
On the shareholder side, the requirements are less onerous. First, the shareholder must be an individual, trust, estate, partnership, S corporation, mutual fund, or common trust fund. Second, the shareholder must have acquired the stock from the company after August 10, 1993 in an “original issuance,” meaning from the company itself in exchange for money, property (other than stock), or services, but not from another shareholder in a cross-purchase. There are exceptions that allow for reorganizations, gifts and bequests of stock, but let’s put those aside for now.
The final requirement is that the shareholder must hold the stock continuously for more than 5 years without engaging in certain transactions that hedge or minimize the risk of owning the stock. The hedging requirement is mostly a non-issue because these companies typically are not publicly traded.
Assuming the issuer and shareholder requirements are met, the shareholder qualifies for an exclusion from gain on the sale of the QSBS. The specific percentage exclusion will depend on the date the shareholder acquired the stock.
In terms of diligence, companies generally seek guidance from a qualified tax advisor early in the process to ensure its owners can qualify for the exclusion. This is because of the magnitude of the exclusion and because of need to keep track of certain requirements over time. It is also important for potential investors – they will want to know whether their expected gain will be QSBS-eligible.