Qualified Small Business Stock: What you need to know

The stockholders of business entities issuing equity have compelling reasons to ensure such shares meet the requirements associated with qualified small business stock (“QSBS”). When selling QSBS upon the business having achieved a successful outcome like being acquired, the holder thereof may not be taxed on all or a part of any relevant capital gains that have accrued.

The QSBS traces its legislative origins to the Revenue Reconciliation Act of 1993. Under such law, a partial exclusion of capital gains tax for certain QSBS was established.

Later, with the passage of the Creating Small Business Jobs Act of 2010, all capital gains associated with QSBS applicable to such law was excluded from taxation.

QSBS was enacted to fuel outside investment in small businesses. External backers are incentivized to provide funding to companies with uncertain prospects by giving them a tax benefit for doing so. Such tax exclusion also pushes founders and other insiders to maximize their efforts to capitalize the business entity.

When determining whether equity securities qualify for the QSBS related exemption, the following considerations are relevant.

1. The corporation must be a “C corporation”.

An S corporation, limited liability company or partnership is not permitted to issue QSBS. The corporation must be a regular corporation (meaning a C corporation) on the date of the issuance of the QSBS in question.

2. The corporation is not permitted to be involved in certain industries.

The business of the corporation cannot be one involving personal services (e.g., those performed in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services or brokerage services); banking, insurance, financing, leasing or investing; farming; mining; or operating a hotel, motel or restaurant.

Companies in the technology, wholesale or retail and manufacturing spaces may issue equity securities that qualify as QSBS.

3. The stock usually is required to be acquired from the business entity itself.

Stockholders are required to acquire their equity for cash, property or as payment for services to the corporation (those acquiring QSBS as a gift or inheritance can still receive the tax benefits associated therewith). At year end, if your corporation is a qualified small business, bonuses may be awarded to employees (including owner-employees) in the form of stock. Generally, the stock given as a year-end bonus is includible in gross income as long as there are no restrictions on it, so employees pay income tax on it (and the value of the stock at issuance is subject to employment taxes). But future appreciation can be transformed into tax-free income.

4. The corporation must be a domestic corporation.

On the date the stock is issued, the corporation must be a domestic corporation. Foreign corporations operating in the U.S. are not permitted to issue QSBS

5. The amount of the exclusion depends on when the stock was issued

The amount of gain excludable depends on when the stock was acquired. The exclusion can range from a 50% exclusion to a 100% exclusion, in each case of gain.

6. The corporation must meet certain financial specifications.

As of the date the QSBS was issued, the corporation must have total gross assets of $50 million or less. This asset limit applies prior to issuance and immediately after issuance of the stock. Gross assets include those of any predecessor of the corporation. All corporations that are members of the same parent-subsidiary controlled group are treated as one corporation.

7. The corporation is required to have business operations.

The corporation is not permitted to be a holding company; in other words, it must be engaged in business operations within a permissible industry. At least 80% of the value of the corporation’s assets are required to be used in the active conduct of one or more qualified businesses

8. The stock must be held for a certain minimum amount of time.

Regardless of when the stock was issued, it must have held for more than 5 years to obtain an exclusion on gain.

9. The amount of gain excludable is capped

The exclusion cannot be more than the greater of $10 million ($5 million for married persons filing separately), minus any gains excluded in prior years or 10 times the shareholder’s basis in the QSBS. Lower limits apply to married persons filing separately.

Is your business planning to issue equity securities? Are you interested in taking advantage of QSBS? If so, contact us to schedule an introductory consultation with Castle Garden Law.