Friday, August 19, 2022

Tax Benefits of Qualified Small Business Stock (QSBS)

For business owners looking for a powerful and exciting tax opportunity, Qualified Small Business Stock is one of the most powerful gain exclusion provisions in the Internal Revenue Code. QSBS allows to exclude from gross income the greater of $10 million or 10 times the initial investment in a qualifying company, with the potential to exclude up to $500 million of gain.

The majority of taxpayers who utilize this option are in the technology sector, owing to the potential for rapid and substantial stock price increases in that industry, but it applies with equal force to manufacturing and other sectors. There are a variety of planning methods that may be utilized to increase and expand the $10 million and 10-times-basis limitations stated above. These techniques, sometimes known as stacking and packing, should not be neglected.

What is QSBS?

Qualified Small Business Stock (QSBS) is a designation for certain stocks that allows investors to exclude their gain from taxation. QSBS is available for C-corporations that meet certain criteria, including:

-Being organized in the United States

-Engaging in an active trade or business (not investing or holding passive assets)

-Having less than $50 million in gross assets at the time of issuance

When QSBS is held for more than five years, investors can exclude the profit (stock sale price minus basis) from taxation. QSBS is a powerful tool that can help business owners save significant amounts on their taxes.


Who Qualifies for QSBS?

To qualify for QSBS, taxpayers must meet the following requirements:

-Be a C-corporation organized in the United States

-Engage in an active trade or business (not investing or holding passive assets)

-Have less than $50 million in gross assets at the time of issuance

When QSBS is held for more than five years, investors can exclude the gain from taxation.

Evaluating whether a business qualifies as a qualifying trade or business (QTB) is a crucial factor in determining QSBS eligibility (QTB). The following firms are excluded from the definition of a QTB in the statute:

A. Any profession or business that involves the provision of services in the areas of medicine, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, finance, brokerage services, or any other profession or business where the main asset of the profession or business is the reputation or talent of one or more of its employees;

B. Any industry related to banking, insurance, financing, leasing, investing, etc.;

C. All agricultural enterprises, including those engaged in growing or harvesting trees;

D. Any firm engaged in the manufacture or extraction of goods for which a deduction is permitted under Section 613 or Section 613A; and

E. Any company that runs a hotel, motel, restaurant, or another comparable enterprise.

Is it possible to lose my QSBS?

Once securities have been exercised and converted within the QSB eligibility window, the resulting QSBS-eligible and QSBS-qualified stock will never lose its attributed tax benefit status or certification (as long as Section 1202 of the tax code remains in effect as currently written). That's regardless of: The company's present QSB situation (or lack thereof). The company merging or being acquired by another business. The stock being transferred, gifted, or inherited.

The following states do not offer the QSBS tax exclusion to shareholders:

  1. California 
  2. Mississippi 
  3. Alabama 
  4. Pennsylvania
  5. New Jersey 
  6. Puerto Rico 

States that offer partial QSBS tax exclusion

If you're a shareholder of a company in one of the following states, you should be aware of some distinct rules.

Hawaii: can exclude 100% from federal taxes and 50% from state taxes on the sale of Qualified Small Business Stock (QSBS).

Massachusetts:  Shareholders must have acquired their stock within the last five years of a company's formation. Shareholders must own QSBS eligible stock for at least three years before they can qualify, as opposed to the usual five years. On state-level income taxes, capital gains will be taxed at a rate of 3%.

Can a (foreign or domestic) firm be acquired under Section 1202?

In accordance with Section 1202, the issuing corporation must be locally incorporated and actively engaged in a qualified trade or business. As long as the parent owns at least 50% of the subsidiary, the statute permits the issuing corporation to look-through to a corporate subsidiary to satisfy this active trade or business criterion.

Although Section 1202 was designed to give small, developing U.S. businesses a tax break, the law doesn't appear to forbid collecting funds in a new C corporation that uses the money to acquire another C corporation. As long as the new C corporation buys at least 50% of the stock of this other "target" C corporation, the acquired C corporation would pass the subsidiary test. The target C corporation may also be a foreign corporation, it would seem.

But given the purpose of Section 1202, it's possible the IRS would challenge employing a supposed QSB as a means of acquisition.

Can a partnership subsidiary's active operation be ascribed to the QSB?

The statute is ambiguous regarding when a parent corporation may "look through" a partnership for the parent's active trade or business test, although Section 1202 clearly states when a subsidiary corporation may be "looked through" for that test (such as multi-member LLC that has not elected to be taxed as a corporation). An individual taxpayer may want to think about one of these options before waiting for IRS guidance:

  • Apply the "corporate" look-through rule: In order to look through a partnership, the parent corporation must own at least 50% of its capital and profits.
  • Apply the "continuity of business enterprise" test to partnerships: if the parent corporation manages the partnership, it must possess at least 20% of the partnership's capital and profits and at least 1/3 of its capital and profits otherwise.
  • No matter the proportion of ownership held by the parent firm, treat any partnership as a "aggregate" of its members and permit a look-through.

Ineligible redemptions

The shares must have been initially issued by the corporation in accordance with Section 1202.

The issuance will be denied QSBS status whole or partially if the corporation redeems disqualified stock. A redemption is ineligible if it takes place within either (a) a 4-year window starting two years before the stock issuance and involves the stock of certain related parties (such as a founder who owns a sizeable portion of the company), or (b) a 2-year window starting one year before the stock issuance and involves the redemption of more than 5% of the total market value of all outstanding stock. 

Prior to making an investment, new investors should research whether the company has made any disqualifying redemptions and look for covenants that state that it won't do so in the future.

Existing shareholders should sell their shares to buyers rather than the company if they want to liquidate their holdings and are aware that potential buyers may ask for QSBS status. The QSBS exemption, however, is unavailable to the buyer because it necessitates the issuance of original stock.

Can a carried interest owner receive QSBS treatment?

Only non-corporate shareholders, such as partnerships, LLCs taxed as partnerships, and S corporations, are eligible for QSBS advantages. Among other obligations, the partners must report on their individual tax returns the percentage of the QSBS gain commensurate to their share of the partnership's adjusted basis in the QSBS.

Sponsors frequently inquire about whether their carried interest is eligible for the QSBS exclusion because many QSBs are funded by venture capital funds established as partnerships.

The rules governing QSBS rollover under Section 1045 prevent the holder of a carried interest from being qualified under that law. The regulations specifically refer to a partner's capital, but a carried interest is a portion of the partnership's profits rather than capital.

What is QSBS rollover (Section 1045)?

If you recently sold your QSBS with a realized gain before the five year holding period ended, the Section 1045 rollover permits you to reinvest your sale proceeds into one or more freshly issued QSB stocks. However, there is a deadline for choosing the 1045 rollover because you only have 60 days to reinvest the earnings from your sell.

How can I transfer QSBS from one business to another?

If you recently sold your QSBS for a realized gain before to the expiration of the five-year holding period, you might want to use the Section 1045 rollover. You have 60 days after the stock is sold to reinvest the sale profits into one or more freshly issued QSB stocks.

Where do I list the QSBS exclusion?

Depending on the year the stock was acquired, QSBS exclusions are mentioned on different tax forms. Form 8949, Schedule D, Form 1045, Form 6251 (if acquired before September 27, 2010), and Form 8960 are some of these documents (if there is a portion of the gain that is not excludable). See Section 1202's detailed filing instructions.