Qualified Small Business Stock (QSBS)

IRC Section 1202 Qualified Small Business Stock (QSBS) 

• Current law (§1202) – A non-corporate taxpayer can potentially exclude up to 100% of the gain realized from the sale or exchange of QSBS held for more than five years

oThe greater of:
i. $10 million (lifetime limit)

or

ii. 10 times the aggregate adjusted basis of QSBS issued by the corporation (annual limit)

oPer issuer limit
oMarried filing separately: $5 million

• An exclusion from federal capital gains tax and 3.8% net investment income tax (§1411)
• §1045 allows a taxpayer to potentially roll-over gain from the sale of QSBS that has been

held for more than 6 months
oMust purchase new QSBS within 60 days of sale

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What is a Qualified Small Business Stock?

Qualified small business stock (QSBS) refers to shares of a qualified small business (QSB) as defined by the Internal Revenue Code (IRC). A QSB is an active domestic C corporation whose gross assets—valued at the original cost—do not exceed $50 million on and immediately after its stock issuance.1

 

Eligible individuals meeting certain criteria are able to receive tax benefits if they hold qualified small business stock (QSBS)

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Requirements:

  1. Issued by a domestic corporation with < $50 million in assets at time of and immediately after issuance

  2. Issued by a corporation that uses at least 80% of its assets in active trade or business (other than personal services)

  3. Held by a non-corporate taxpayer (partnerships & S corps qualify)

  4. Acquired by taxpayer on original issuance

  5. Held for more than 5 years

Active Business Requirement

  • At least 80% (by value) of assets must be used by the corporation in the active conduct of one or more “qualified trades or businesses” . Exceptions:

  • Reasonable working capital needs

  • R&D expenses

  • Start-up expenses

  • 10% limit: portfolio securities

  • 10% maximum real estate holdings

“Original Issuance” Requirement

QSBS must generally be acquired at “original issue” (directly or through an underwriter) in exchange for:

  • Money

  • Property other than stock

OR

  • Compensation for services performed for such corporation

 

Qualifications:

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  • QSBS does not apply to equity interests in pass-through entities, such as S-corps or partnerships

  • Only C corp stock

  • QSBS held by a pass-through entity:

    • May potentially qualify for the §1202 exclusion

    • Must have held the interest on the date the entity acquired the QSBS

    • Must have held the interest all times thereafter until the stock was sold

Qualified Trade or Business

  • The following are not considered qualified trades or businesses:

    • Any trade or business involving the performance of services in the fields of health care, law, engineering, architecture, accounting, financial services etc.

    • Any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees

    • Banking, insurance, financing, leasing, investing or similar business

    • Farming business

    • Any business eligible to claim a deduction for depletion

    • Businesses of operating a hotel, motel, restaurant or similar business

  • Note: IRC §199A uses part of the language from above

QSBS Holding Period

  • The holding period begins on the date of issuance

  • The holding period also tacks on in the case of tax-free incorporation (under § 351) or a reorganization (under § 368)

    • Limitation: QSB stock treatment will be limited to the amount of gain accrued when rolled over into nonqualified small business stock unless the acquiring corporation is a qualified small business, in which case the stock issued is treated as entirely QSB stock

  • The holding period of QSBS acquired in a §1045 rollover transaction generally tacks on

  • QSBS held for less than 5 years when sold, still has the opportunity to rollover proceeds into new QSBS stock with tacked on holding period

  • Stock options, warrants, convertible debt:

    • Do not qualify as QSBS until exercised/converted

  • Acquisition date for stock-based compensation:

    • Incentive stock options: date of exercise

    • Restricted stock no §83(b) election: date of vesting

    • Restricted stock §83(b) election: date of election

• Recipient is considered to own the stock when they have an unrestricted right to the shares

• Holding period tacks for convertible preferred stock to common stock