What is the benefit of Qualified Small Business Stock?
Qualified Small Business Stock (QSBS) allows non-corporate taxpayers (individuals, partnerships, etc.) to exclude up to 100% of the realized gain from the sale or exchange of QSBS acquired after September 27, 2010 to present. This exclusion applies to the federal tax return but not all states comply (for example, California does not conform). As such, you will need to review the rules for each state that you file income tax returns in to determine if the exclusion applies for state income tax purposes.
The gain exclusion percentages vary depending on when the stock was acquired as noted below:
- 50% Gain Exclusion: Stock acquired between 8/11/1993 – 2/17/2009, subject to an AMT adjustment of 7% of the excluded gain
- 75% Gain Exclusion: Stock acquired between 2/18/2009 – 9/27/2010, subject to an AMT adjustment of 7% of the excluded gain
- 100% Gain Exclusion: Stock acquired 9/28/2010 and after, not subject to an AMT adjustment
- 60% Gain Exclusion: Empowerment Zone stock acquired after 12/21/2000 and sold on or before 12/31/2018
What is Qualified Small Business Stock?
The purpose of QSBS is to encourage investment in small businesses. To be eligible as a Qualified Small Business Stock, it must meet the following requirements as identified in Internal Revenue Code (IRC) Section 1202:
- Any originally issued stock of a C corporation issued after August 10, 1993 to a non-corporate shareholder (individual, partnership, S Corporation, and/or trust)
- On the issuance date, the corporation must be a qualified small business (aggregate gross assets before the stock issuance does not exceed $50 million). Once a corporation fails the $50 Million Test, even if only for a day, the corporation can no longer issue QSBS.
- A corporation qualifies as an active business throughout the taxpayer’s holding period.
- An eligible Corporation is any C Corporation not including an international sales corporation, regulated investment company, real estate investment trust, real estate mortgage investment conduit, or a cooperative.
- The Corporation uses at least 80% of the asset value in the active conduct of at least one qualified trade or business.
- A qualified trade or business is as any trade or business with the exception of, and not limited to, services related to health, law, engineering, architecture, accounting, financial services, and other businesses where the principal asset is based on the skills of its employees. It also excludes hotels, motels, restaurants, farming, banking, insurance, and any similar business.
- The stockholder must hold the stock for a minimum of 5 years.
It is imperative that the shareholder obtain documentation from the issuing C corporation that the above requirements are met to avoid any additional significant capital gains tax, penalties and interest if the position claimed for gain exclusion is denied under IRS audit.
How can individuals maximize their QSBS benefits?
Individual taxpayers can maximize their QSBS benefits by gifting to non-spouse individuals, non-grantor trusts, or estates. Because QSBS federal capital gains exclusion is capped at the greater of $10 million or 10x the adjusted basis of the shares, you can “stack” the QSBS exclusion by gifting the fair market value (FMV) of the shares to multiple taxpayers (individuals, trusts, or estates) to avoid the capital gains in excess of the maximum federal capital gains exclusion. Each taxpayer can take advantage of the $10 million exclusion (or 10x the adjusted basis).
Gifting to Individuals: This must be made only to a non-spouse family member such as child, parent or sibling. However, you as the gifter lose control of these direct gifts to individuals and it is not protected against creditors.
Gifting to a Trust: The gifter can set up a non-grantor irrevocable trust for each child or other family member, each who is assigned as the trust’s beneficiary. Each trust benefits from the $10 million exclusion.
Since the gift is based on the FMV of the contributed shares at the time of gifting, it is more beneficial to gift sooner than later when the asset valuations are lower. Such gifts do use up your lifetime gift tax exemption. As of 2024, the lifetime gift tax exclusion is $13.61 million, and the annual gift tax exclusion is $18,000.
Rollover Gain: Under IRC Section 1045, a non-corporate taxpayer may elect to rollover the sale of their qualified small business stock by purchasing another small business stock (the replacement stock). This transaction defers the gain realized on the sale of the original stock. However, a portion of the gain may not be deferred if the cost of the replacement stock is less than the amount realized on the original QSBS.
Additionally, the replacement stock’s basis is also reduced by the realized gain of the old stock (original QSBS sales price – original QSBS cost basis) less the recognized gain (original QSBS sales price – replacement stock cost basis).
To qualify, the original QSBS must be held for more than six months and exchanged within the 60 day window beginning from the sale date. This is beneficial to taxpayers who do not meet all the IRC Section 1202 requirements previously stated above, and there is no limit on how often a gain is rolled over.
Aura Advisors is a boutique tax consulting and compliance firm working with start-ups, emerging growth companies, and affluent individuals. Making it safer for good people and good companies to continue to do good things.