Under the right circumstances, qualified small business stock (QSBS) offers tax savings for business owners. Essentially, QSBS allows them (and their heirs) to sell their stock free of capital gains tax. This tax break is subject to several strict requirements, but the benefits can be substantial for those who qualify.
QSBS was created by Internal Revenue Code Section 1202 and initially allowed qualifying taxpayers to exclude 50% of their capital gain from the sale of QSBS. That amount temporarily increased to 75% in 2009 and 100% in 2010. In 2015, Congress made the 100% exclusion permanent for QSBS acquired after September 27, 2010.
To qualify as QSBS, a U.S. C corporation must issue the stock to an individual or pass-through entity. In addition, the issuer must be:
A small business. The business’s aggregate gross assets must not exceed $50 million after August 10, 1993, or immediately after the stock is issued. If the issuer owns more than 50% of another corporation’s stock, the subsidiary’s assets are included for purposes of the gross asset test. A corporation isn’t disqualified if its assets grow beyond the threshold after issuing the stock.
An active business. The business must use at least 80% of its assets (by value) to conduct one or more qualified active businesses. In addition, no more than 10% of its assets can consist of nonbusiness real estate.
A qualified active business is any trade or business other than:
Beware: The QSBS exclusion applies only to federal income tax. Some states don’t follow Sec. 1202, so state-level taxes may still apply.
To qualify for the favorable treatment, a shareholder must not be a C corporation and must acquire the stock as part of an original issuance. In other words, the shareholder must acquire the stock directly from the corporation (or through an underwriter), not from another shareholder, in exchange for money, property (other than stock), or as compensation for services. This requirement has certain exceptions, including for stock received by gift or inheritance.
In addition, the taxpayer must hold the stock for at least five years after issuance. However, if the stock is received by gift or inheritance, the transferor’s holding period is added to the recipient’s.
If QSBS is converted into a different stock of the same corporation, the original stock’s holding period is added to the new stock’s holding period. If the stock is sold in less than five years, the taxpayer can preserve the tax benefits by rolling over the gain into another QSBS within 60 days.
This exclusion isn’t unlimited, however. The amount of QSBS gain on a particular issuer’s stock that a taxpayer may exclude each year is limited to the greater of 1) $10 million, or 2) 10 times the taxpayer’s aggregate adjusted tax basis in stock sold during the tax year.
QSBS offers significant tax benefits, but it’s not for everyone. It’s important to weigh the advantages of tax-free capital gains against the disadvantages (including double taxation of dividends) of operating as a C corporation. Your tax advisor can help answer any questions.
This material is generic in nature. Before relying on the material in any important matter, users should note date of publication and carefully evaluate its accuracy, currency, completeness, and relevance for their purposes, and should obtain any appropriate professional advice relevant to their particular circumstances.
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