Qualified Small Business Stock: Do You Qualify for Its Taxable Gain Exclusion?
Article Highlights:
- Sec1202 – Qualified Small Business Stock (QSBS)
- Exclusion Periods & Exclusion Percentages
- Maximum Exclusions
- Strategies
- Shareholder Qualifications
- Corporate Level Requirements
- Retaining QSBS Status
- Employee Benefits
- State Taxation
- Conversions of an Existing Business
- Rollovers
IRC Sec 1202, Qualified Small Business Stock (QSBS) gain exclusion, provides a significant tax planning strategy. Sec 1202 was enacted in 1993 to encourage investment in small businesses. It allows individuals to avoid paying taxes on up to 100% of the taxable gain recognized on the sale of qualified small business stock (QSBS) of a C corporation.
Whether a new business, or rethinking your existing business structure, Sec 1202 could be right for you. While this tax strategy is designed to be a benefit to small business owners, some larger businesses can qualify. The benefits of Sec 1202 are a permanent exclusion of gain rather than a deferral of gain like many other tax benefits. However, qualifying as QSBS can be complex so it’s important to seek professional assistance. The following is only an overview of the qualifications for this tax benefit.
When Section 1202 was originally enacted it allowed 50% of the gain from selling QSBS to be excluded. It was not initially popular, and the exclusion was increased to 75% and then later to 100%. Thus, there are three time periods when the qualifying stock is purchased with the corresponding gain exclusions as illustrated in the following table:
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Stock Issued
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Sec 1202 Exclusion
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Beginning Date
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Ending Date
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Percentage
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8/11/1993
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2/18/2009
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50%
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2/19/2009
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9/27/2010
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75%
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9/28/2010
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Continuing
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100%
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So, individuals acquiring QSBS qualified small business stock September 28, 2010, or later that was originally issued after August 10, 1993, can avoid paying taxes on up to 100% of the taxable gain recognized on the sale of the QSBS. And even though it’s framed as a small business tax incentive, a business can be quite large and still qualify as a “small business” for this purpose.
If the QSBS was acquired after September 27, 2010, the qualified stockholder could permanently exclude up to $10 million of the gain on sale of the stock or 10 times their aggregate adjusted basis of the QSBS.
Example: Assuming an exclusion of $10 million and based on a 23.8% federal tax rate (made up of the 20% capital gains tax rate plus the 3.8% net investment income tax) and a 6% assumed state income tax rate, a qualifying stockholder could potentially save $2.98 million ($10 million x 29.8%) in federal and state taxes. Of course, this is true only if the stockholder’s state also permits the gain to be excluded.
For stock issued after August 10, 1993 and acquired between 1993 and 2010, the amount of gain that avoids taxation can be 50% or 75%, depending on when the stock was acquired.
Maximum Exclusion for QSBS Acquired After Sept 27, 2010 (100% Exclusion)
For stock issued after Aug. 10, 1993 and acquired after September 27, 2010, the gain exclusion is the greater of:
- 10 million – The $10 million is a cumulative limitation and is reduced by the amount of eligible gain excluded in previous sales of QSBS with respect to each corporation.
- 10X basis limitation – The 10X basis limitation allows a taxpayer to exclude up to 10 times their basis of the QSBS sold in a given tax year, regardless of the number of QSBS sales or the amount of gain the taxpayer previously excluded.
Example: A QSBS holder, Sebastian, was originally issued the stock on January 15, 2016, in exchange for a cash payment of $3 million. Sebastian subsequently sold the stock on October 10, 2023, for $23 million, resulting is a $20 million gain. Since the stock is QSBS under Sec 1202, Sebastian can exclude the greater of $10 million or 10 times his initial basis of $3 million or $30 million (10 x $3 million). Thus, Sebastian can exclude the entire $20 million gain, paying no federal tax on the gain.
Strategies — There are strategies based upon the circumstances of each sale that require careful consideration when applying either the $10M cumulative exclusion limitation or the 10X basis limitation.
- Basis Limitation Can Exceed $10M Cumulative Exclusion — A taxpayer who has a large basis in QSBS should consider the benefit of their QSBS basis when planning a sale. Using the 10X basis limitation on a sale of QSBS with high basis may provide a gain exclusion that exceeds the amount available under the cumulative limitation. The basis of any QSBS the taxpayer still owns or sold in previous years is not considered. This is significant when some shares have greater basis than others or are sold over time.
- Sales Over 2 or More Years — Taxpayers can use the $10M cumulative exclusion in year one and the 10X basis limitation in subsequent years. Or as an alternative, use the $10M cumulative exclusion on the sale of shares with a lower basis and the 10X basis limitation on higher-basis shares.
Computing the Exclusion for QSBS Subject to the 50% or 75% Exclusion
For QSBS stock subject to the50% and 75% exclusions, first, the $10 million cumulative limitation or the 10X basis limitation is applied to determine the amount of eligible gain resulting from the sale. Next, the actual amount of gain excludable is determined by multiplying that eligible gain by the appropriate 50% or 75% limitation.
Seven percent of the 50% or 75% excluded Sec 1202 gain is treated as a tax preference for alternative minimum tax purposes. However, for dispositions of qualified Sec 1202 stock issued after September 27, 2010, and held for over 5 years, the excluded gain (100%) does not count as a preference item. (Code Sec. 1202(a)(4))
Requirements to Qualify for Section 1202 Gain Exclusion
Stock must meet eight requirements to qualify for Section 1202 benefits. Following is an overview of each of these requirements.
A. Shareholder-level Requirements
1. Eligible Shareholder – The stock must be held, directly or indirectly, by an eligible shareholder. Eligible shareholders are non-corporate shareholders including individuals, trusts, and estates. Suppose the shareholder is a partnership or S corporation. In that case, the gain may still qualify, but there are additional requirements that must be met for non-corporate owners of the pass-through entity to claim the benefits of Section 1202. Only U.S. taxpayers qualify for the Sec 1202 benefits.
2. Holding Period – The stock must be held for more than five years before it’s disposed. Generally, the holding period of the stock begins on the date the stock was issued. Suppose stock was issued in exchange for non-cash property. In that case, the Section 1202 holding period still begins on the exchange date even if the holding period for general tax purposes carries over.
If the stock is issued from the conversion of debt or the exercise of stock options or warrants, the holding period doesn’t begin until the conversion or exercise. Additionally, some hedging transactions can disqualify stock from Section 1202 treatment.
In determining whether a shareholder has met the five-year requirement, a shareholder can “tack on” previous holding periods if the stock was inherited, received as a gift, in a distribution from a partnership, or in certain stock conversions or exchange.
3. Original issuance of stock – The taxpayer must have acquired the stock on original issuance after Aug. 10, 1993. Consequently, the stock must be purchased from the company, rather than another shareholder. However, the stock doesn’t have to be issued as a part of the initial incorporation. Stock received as compensation for services provided to the corporation meets this requirement (see more on this later). However, stock that’s received in exchange for other stock can sometimes qualify, although it’s subject to additional requirements.
In certain situations, stock can be treated as having been received at original issuance even when the shareholder is not the original owner of the shares. When stock is received via a gift, at death, or as a distribution from a partnership, the stock is treated as having been received by the transferee in the same manner as the transferor. Thus, if the stock was acquired by the transferor at original issuance, the transferee will be treated as having done the same. In other words, theholding period of the original owner is tacked on to the subsequent owner.
For stock distributed from a partnership to a partner, to meet the definition of QSB stock in the hands of the partner:
(1) the stock must have been QSB stock in the partnership’s hands (ignoring the five-year holding period requirement),
(2) the partner must have been a partner from the date the partnership acquired the stock through the date of the distribution, and
(3) the partner cannot treat stock the partnership distributed as QSB stock to the extent the partner’s share of the distributed stock exceeds the partner’s interest in the partnership at the time the partnership acquired the stock.
Committee reports clarified that the issuance date is determined in accordance with the rules of Sec. 83.
Example: In 2015, Jack receives 2,000 shares of QSBS stock in exchange for services provided. The stock is restricted and nontransferable until 2020. Jack does not make a Sec. 83(b) election. In 2020, Jack fully vests in the stock, and at that time, in accordance with Sec. 83, Jack includes the FMV of the stock in income. For purposes of Sec. 1202, the stock’s issuance date is 2020, when the stock vested.
When convertible QSB stock is converted into other stock of the same corporation, the stock received in the conversion is treated as QSB stock, and the date of issuance is the date the convertible stock was originally acquired by the shareholder (Sec. 1202(f)).
Example: Jack is issued 2,000 shares of convertible preferred stock in Widget Inc., in 2018. The convertible preferred stock meets the definition of QSBS. In 2021, Jack converts the stock into 4,000 shares of Widget Inc. common stock. The common stock received by Jack is treated as QSBS, and Jack is treated as having originally acquired the common stock in 2018.
When stock is received via gift, inheritance, or as a distribution from a partnership, the acquisition date is the date on which the transferor acquired the stock (Sec. 1202(h)(1)(B)).
Example: On June 1, 2016, Jack contributes $1,000 to X Co. in exchange for stock. The stock meets all the requirements of QSB stock. On July 15, 2020, Jack gifts the shares to Sally, his sister. In July 2021, Sally sells the stock. Because Sally is treated as having acquired the stock on June 1, 2016, the five-year holding period is met.
B. Corporation-level requirements
4. Eligible Corporation (Sec 1202(e)(4)) — Generally the corporation must be a domestic C corporation. The corporation must be an eligible corporation when the stock is issued and during substantially all the taxpayer’s holding period. An eligible corporation is any domestic C corporation other than certain limited exceptions (such as IC-DISC, former DISC, RIC, REIT, REMIC, or cooperative). An S corporation is not an eligible corporation, but an LLC that has elected to be taxed as a C corporation is eligible. Furthermore, while the corporation must be domiciled in the U.S., the activity of that corporation or its subsidiaries can be domestic or international.
5. $50 Million Gross Assets Limitation – The corporation must not have had more than $50 million of tax basis in its assets at any time between Aug. 11, 1993, through the moment immediately after the issuance of the stock. This test is evaluated at the time of each stock issuance. Once the asset test is met, this test is not reevaluated at a later date for that stock. Therefore, stock issued when the corporation has less than $50 million in tax basis in its assets continues to qualify, even if the corporation’s assets later exceed $50 million.
CAUTION: Acquisitions, fundraising rounds, licensing agreements, and inventory can cause a company to exceed this threshold and lead to QSBS disqualification.
6. Redemption Transactions – Because Congress intended to encourage investment in small business corporations, it wanted to prevent situations where capital invested for Section 1202 was used to fund redemptions of other shareholders. To prevent this type of undesirable activity, Congress cast a wide net in disqualifying stock that is issued shortly before or after a redemption of stock. This is one of the most common traps for taxpayers and results in inadvertently disqualifying stock that met all the other requirements.
7. Qualified trade or business requirement – The corporation must be engaged in (or performing activities to start up) a “qualified” trade or business. This includes any business other than those in the businesses listed below. Unfortunately, there’s very limited guidance on exactly what most of these terms mean and how broadly they should be construed, leaving room for interpretation by both taxpayers and the IRS. Prohibited businesses include:
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- Professional service businesses including in the fields of health, law, engineering, accounting, consulting, brokerage, and like businesses.
- Performing arts, athletics or any trade or business where the principal asset of the trade or business is the reputation or skill of one or more of its employees.
- Banking, financing, leasing, investing, and like businesses.
- Farming and gardening
- Oil, gas, & mining
- Hospitality including hotel, motel, restaurant, and like businesses.
- Real estate & other passive businesses
8. Active business requirement – The corporation must use at least 80% of the fair market value of its assets in the active conduct of a qualified trade or business. This requirement must be satisfied during substantially all the taxpayer’s holding period of the stock. Further, only up to 50% of the corporation’s assets can be made up of working capital held to support reasonable needs of the business or to support research.
For purposes of this requirement, a corporation automatically fails to meet this test if:
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- 10% or more of the corporation’s net assets consist of stock or securities in other corporations in which the corporation does not own over 50%; or
- 10% or more of the corporation’s gross assets consist of real property not being used in the active conduct of a qualified business.
Retaining QSBS Status – Once securities have been exercised and converted within the QSB eligibility window, the resulting stock is unlikely to lose its attributed tax benefit status and certification (if Section 1202 of the tax code remains in effect as currently written). That’s regardless of:
1. The company’s current QSB status (or lack thereof).
2. Whether the company has merged or has been acquired by another corporation. (Except if the company was acquired before the five-year period ended, in which case the QSBS holder would no longer be eligible for this benefit.) Note: In a merger or acquisition scenario, one of the following, or a combination, can occur, depending on the transaction:
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- QSBS holders may be able to conduct a share-for-share transfer in which shares are exchanged for shares in the acquiring company; in this case, QSBS status is maintained, but the capital-gains exclusion is capped at the transaction value rather than the full $10 million investment cap;
- QSBS holders, for example high-net-worth individuals, may cash out and defer capital gains by investing into another QSBS company.
3. Whether the stock has been transferred, gifted, or inherited. (Except if the stock was transferred to a partnership, in which case it would lose its QSBS status.)
The following are some examples of when stock may lose its QSBS certification:
1. If the company performs a disqualifying repurchase.
2. If the company changes its business model and begins to operate as an excluded business type.
Employee Benefits –It is permissible to issue QSBS in exchange for services, which can be a useful tool for startups and other companies short of cash to compensate employees. It also works as an inducement to retain employees; their stake in the company is incentive to work hard and help it succeed. However, there the employer will have to pay half the payroll taxes on the employee benefits.
State Taxation -If the shareholder of company stock is a resident in one of the following states or territories, the shareholder is not eligible for the QSBS tax exclusion at the state level (as of the publication of this article):
1. Alabama
2. California
3. Mississippi
4. New Jersey
5. Pennsylvania
6. Puerto Rico
Hawaii and Massachusetts partially conform with the QSBS tax exclusion. The requirements vary based on the state of incorporation (for the company) and the state of residency (for the shareholder).
Conversions of an Existing Business
S corporation to C corporation – For stock to meet the definition of QSB stock, the issuing corporation must be a C corporation on the date of issuance. Thus, if an S corporation that otherwise meets all the requirements of a qualified small business under Sec. 1202 issues stock, that stock can never qualify as QSB stock, even if the S corporation later converts to a C corporation. Thus, if the S corporation revokes or terminates its election, it will need to issue new shares of stock while meeting all the requirements of Sec. 1202, for the issued stock to meet the QSB stock requirements.
Partnership to C corporation – Rev. Rul. 84-111 provides three methods for an existing partnership to convert to a C corporation. Each method allows the partners-turned-shareholders to qualify for the benefits of Sec. 1202.
Rollovers– Under Section 1045 of the Internal Revenue Code, a taxpayer can roll over a capital gain from the sale of QSBS that has been held for more than six months. To do so, the taxpayer must purchase new QSBS-eligible stock within 60 days of the sale and make an election on their tax return.
This is particularly advantageous in cases where the issuing company is sold prior to the QSBS five-year holding period, as it may allow shareholders to defer taxes by rolling over their capital gains into a new QSBS-eligible company.
This is only an overview of the benefits and qualifications related to QSBS. However there a multitude of other issues effecting QSBS including acquisitions, mergers, conversions etc. not covered here. Please contact us for details related to your specific situation.