Understanding the QSBS Tax Exclusion

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Early investors (founders, angel investors and early adopters) often have the opportunity – if lucky – for growth in the value of their initial investment to far exceed their basis. That growth is a double-edged sword, as it can result in significant tax obligations when the stock is eventually sold. However, if the stock meets the requirements to be classified as Qualified Small Business Stock (QSBS), under section 1202 of the Internal Revenue Code, all or a significant portion of the gain on such a sale can be excluded from income for federal tax purposes.¹ The ability to exclude up to $10 million from capital gains on the sale of QSBS can save taxpayers up to $2,380,000 in federal income tax (20% maximum capital gains tax rate plus 3.8% net investment income surtax).

For stock acquired before September 27, 2010 taxpayers can only exclude a portion of the gain, instead of all the gain. Based on the acquisition date, this results in a portion of the proceeds being excludable under section 1202 (excluded gain), and the remainder being subject to tax at regular rates, including the excise tax on net investment income (included gain).² The cumulative tax rates are shown in the table below.

As the charts illustrate, the exclusion of QSBS proceeds from capital gains tax is an attractive proposition. However, the rules of QSBS gain exclusion are complex and there are many traps for the unwary.

Tax incentives for QSBS ownership

Congress enacted section 1202 in 1993 to provide an incentive for investors to buy stock in small business ventures which traditionally have had more challenges attracting capital than larger enterprises. In the ensuing 30 years, additional changes to the statute have only enhanced the tax benefits of QSBS investments. Today, investors may exclude the greater of (a) $10 million or (b) ten times the investor’s basis in the stock from capital gains tax on QSBS purchased after September 27, 2010.⁶ QSBS treatment is not limited to shareholders who are individuals – any taxpayer other than a C corporation is eligible to claim the benefit of the exclusion from gain from the sale of QSBS.

Qualifying for QSBS treatment

As with many favorable tax provisions, the devil is in the details. Qualifying for QSBS treatment requires careful attention to a range of applicable factors necessary to qualify for gain exclusion under section 1202.

There are three points in time to evaluate an investment’s qualification as QSBS:

The first of these is at the time the investment is made. When the investor acquires the stock:

• The corporation must be a domestic C corporation for income tax purposes, although an S corporation, LLC or partnership can convert to a C corporation for this purpose.
• The taxpayer must acquire the QSBS directly from the issuer for cash or in exchange for services (other than as an underwriter). Stock acquired from third parties or in exchange for other stock does not qualify.
• The company must qualify as a small business, with gross assets of less than $50 million, at all times after 1993, up until the acquisition by the shareholder of the QSBS and immediately after that transaction.⁷
• The company must be engaged in specific, permitted business activities. Most services, including investments, law, athletics, accounting and medicine, as well as other businesses such as hotels, restaurants, farms and financial services companies are excluded from the definition of “qualified business.”
• The company must use at least 80% of its assets in an active trade or business.

It is vital to evaluate these issues upfront at the time the initial investment is made. While not every small business investment will generate gains requiring QSBS treatment, the QSBS treatment will not be available for any investment that does not satisfy the initial requirements. This makes QSBS factors important not just to those selling small business stock, but also to those structuring venture capital and private equity deals, companies using equity compensation plans and entrepreneurs establishing new businesses.

The second significant point in time for analysis is at the time of a permitted transfer. Permitted transfers include:

• Transfers by gift or at death.
• Distributions from a partnership.
• Rollover of proceeds from one QSBS company to another issuer that qualifies as a QSBS.
• Certain permitted reorganizations of the issuing corporation.
• Conversion of other QSBS stock held by the taxpayer in the same company (e.g., a stock dividend).

If QSBS stock is acquired in a permitted transfer, the holding period of the original owner carries over to the new shareholder and the stock is treated as having been acquired in the manner the transferor acquired it.

The final time to analyze the stock’s eligibility is at the time the shares are sold:

• The shareholder must have held the stock for at least five years prior to sale. For stock acquired in exchange for services, the period begins when the employee is taxed on the income. For stock acquired by exercise of options, conversion of stock or exercise of warrants, the period begins at the original issue. For QSBS acquired in a permitted transfer, the period begins when the donor acquired the stock from the company (that is, the holding periods are tacked together).
• The $10 million dollar rule applies as a lifetime cap, so if a shareholder sells $5,000,000 in shares in year one and another $5,000,000 in shares in year two, QSBS treatment is allowed for both sales.
• The rules apply per issuer of stock, so taxpayers who invest in multiple small businesses could take the QSBS exclusion from gain on multiple occasions.
• For a married couple filing jointly, the sale is treated as half by each of them, regardless of who owned the stock originally.

QSBS tax planning opportunities

Although the QSBS rules are complex, they do present opportunities for tax planning. For example, if a taxpayer has more than $10 million of gain in QSBS stock, she can make a gift of some of the stock to another taxpayer (such as an individual or non-grantor trust). Both the donor and the donee will be treated as having QSBS stock and each can use section 1202 to exclude up to $10 million in gain.

Similarly, if a taxpayer does not want to recognize gain at the time they sell their QSBS investment, they can roll over the proceeds of the QSBS investment into a new permitted QSBS investment and defer recognition of the gain until they sell the shares in the new entity. Since the caps are “per issuer” of stock, serial entrepreneurs and other investors may have multiple opportunities to use the $10 million exclusion. For more insights on QSBS, consult a Northern Trust advisor.