Qualified small business stock

Selling a business you’ve spent years building and growing is a major decision. It involves factors like securing a good sale price, ensuring a smooth transition, and figuring out what to do with the proceeds.

Understanding the tax implications of the sale is also an important part of the process. Typically, in a stock sale entrepreneurs will pay capital gains tax on the appreciation in their share price. However, with careful planning, owners may be able to exclude 100% of their capital gains if their shares qualify as Qualified Small Business Stock (QSBS).

This powerful provision is widely overlooked, yet it can potentially allow a business owner to sell his or her stake at significant gains while paying zero tax on the profits. Unlike a 1031 exchange or Qualified Opportunity Zone Fund, this is not merely a tax deferral strategy.  The preferential tax treatment of QSBS allows founders, business owners, and investors to shield some or all of the gains resulting from the sale of QSBS stock.

While obviously appealing, a corporation’s stock must meet very specific requirements and conditions to qualify (if it does not, there may be other ways to qualify). To better understand this powerful exemption, we sat down with Westmount partner and senior advisor Scott Fellmeth for a high-level overview of QSBS, how it works, and who can benefit.

What specifically is the advantage of Qualified Small Business Stock?

Section 1202 of the Internal Revenue Code stipulates that upon the sale of QSBS stock, a taxpayer can exclude from federal taxes a gain equal to the greater of $10 million (less any gains already taken) or 10 times the taxpayer’s adjusted basis in QSBS stock, provided that certain conditions are met.¹

What are the requirements for a stock to be QSBS?

For stock to qualify as QSBS, it must satisfy the following requirements:

1. The company must be a C corporation. Other types of entities, like S corporations, limited partnerships, and most LLCs, do not qualify.
2. The company must have gross assets of $50 million or less at the time the stock was issued. If the company’s gross assets exceed $50 million after that point, it cannot issue QSBS again, but previously issued stock remains valid.
3. The stock must have been issued after Aug. 11, 1993.
4. The stock must be held for at least five years.
5. The corporation must be eligible and involved in a qualified trade or business.
6. The stock must have been acquired by the shareholder directly from the corporation at its original issue

The amount of gain that a seller can exclude depends on when the shares were initially acquired. The full exemption applies for qualified shares acquired after Sept. 27, 2010. For shares acquired between Feb. 17, 2009, through Sept. 27, 2010, one can exclude 75% of the qualified gain, and for stock acquired after August 11, 1993 and before Feb. 17, 2009, the exclusion is capped at 50% of the gain.

What businesses qualify for QSBS?

Many types of businesses qualify for the QSBS exemption. Technology companies, manufacturers, and retailers are the most common examples. However, business owners should consult with legal counsel to be certain.

Broadly speaking, any business involved in providing services is excluded. This includes businesses that provide banking, investment, insurance, engineering, law or accounting services, as well as performing arts, health/medical offices, and consulting businesses. Fossil fuel producers, farmers, and hotel/restaurant operators are also ineligible.

Can I convert my existing business into a C corporation to qualify?

This is possible, but there are a few caveats. For example, an S corporation could convert to a C corporation to issue QSBS stock, assuming it meets all of the other requirements laid out in Section 1202. However, only stock issued after the conversion would qualify. The same is true for limited partnerships.

Converting from an LLC, on the other hand, is a more complicated scenario but can be successful under the right circumstances.² Regardless of your corporate structure, consulting with a tax attorney with expert knowledge of Section 1202 will be critically important  as you evaluate your options.

Does the QSBS exclusion extend to state taxes?

In most states, yes (excluding residents of California, Alabama, Mississippi, New Jersey, Pennsylvania and Puerto Rico). Hawaii and Massachusetts conform partially, based on where the business is incorporated and the shareholder’s state of residency.

Can I gift QSBS shares?

Yes. This is known as “QSBS stacking” and usually involves gifting shares to family members and/or irrevocable trusts. Stacking can be extremely advantageous because each recipient is eligible for a fresh exclusion on capital gains. ³

However, the IRS has not provided concrete guidance on how aggressive one can be in stacking QSBS, such as whether each spouse qualifies for their own exemption. Therefore, we strongly advise business owners to consult with their tax and legal advisors before engaging in QSBS stacking, as the strategy is not without risk of IRS scrutiny.

Why aren’t more business owners taking advantage of QSBS?

Section 1202 was originally introduced to the tax code over 30 years ago but has remained a relatively obscure measure for most of its existence.⁴ This is mostly due to the fact that high corporate tax rates, a reduced gain exclusion, and a relatively low capital gains rate during the 90s and early 2000s meant that the effort required to meet the eligibility requirements often outweighed the potential benefits.

This changed with the passage of the 100% exclusion provision in 2010 and, more recently, the 2016 Tax Cuts and Jobs Act, which introduced a significant drop in the corporate tax rate. Consequently, there has been relatively little case law and IRS guidance on QSBS in the last 30 years.

In other words, business owners and investors looking to take advantage of QSBS exclusion should keep careful records if the IRS challenges their eligibility. We also recommend obtaining appropriate legal and tax guidance before proceeding with any strategy, such as QSBS stacking.

What next?

If you’re thinking about selling your business and want to take advantage of the Qualified Small Business Stock exclusion, it’s important to consult with your financial advisor, tax attorney, and other advisors well in advance of the sale. Westmount can help you marshal the necessary resources, coordinate with the other members of your team, and do whatever else is needed to ensure a smooth and successful transition. Learn more here, or contact us to speak with an advisor today.