Who wouldn’t love to sell their business, or a successful angel investment, totally income tax-free? If selling tax-free sounds good, it is time to learn about qualified small business stock (QSBS). QSBS applies to shares of a U.S. C corporation that had less than $50 million of assets at the time of the investment. Shares from limited liability companies (LLCs), S corporations, and partnerships are not qualifying stock – although read on, as some of these entities can be converted to qualify.
QSBS companies typically include firms in sectors like technology and manufacturing, but not those in sectors like hospitality, professional services, finance, and agriculture. Capital gains from the sale of QSBS are partly or wholly exempt from federal taxes and likely state income taxes as well. This capital gains exclusion does have some limits, but before we share the bad news, let’s flesh out what type of stock can potentially be sold tax-free under the QSBS exemption.
Shares Must Be Held for Five Years
A business must hold shares for at least five years from the date they are acquired to the date they are sold to receive QSBS treatment. If shares are converted or exchanged into other stock in a tax-free transaction, the holding period of stock received includes the holding period of the converted or exchanged stock. For shares received by gift or inheritance, the holding period includes the period the donor or decedent held the stock.
Shares Must Be Acquired Directly from the Company, Not on the Secondary Market
In the U.S., the QSBS must have been acquired after 1993 directly from a domestic C corporation or its underwriter in exchange for money, property, or services. In other words, shares purchased on the secondary market are not QSBS.
There are rules in place to prevent corporations from simply redeeming shares and reissuing stock at original issuance to qualify it as QSBS. As such, if certain redemptions occurred within a specific time period before the selling shareholder received his or her shares, QSBS treatment may be unavailable.
Suppose the selling shareholder acquired the stock by gift from or upon the original shareholder’s death. As long as the original shareholder received the QSBS at original issuance, the shares are deemed to have been acquired at original issuance.
The Business’s Gross Assets Cannot Exceed $50 Million
Herein lies the first “S” in QSBS – small. The goal of the QSBS election’s creation was to encourage investment in small businesses, and applicable tax rules essentially define small as having no more than $50 million of assets from the company’s inception until immediately after the shareholder receives the QSBS.1
The amount of assets the business has or its value upon sale is irrelevant. The tax rules, found in Section 1202 of the Tax Code, provide that the business owns a proportionate amount of the assets and performs a proportional amount of the activities (a relevant consideration in the next requirement) of its subsidiaries.
The Company Must Be Involved in a Qualified Active Trade or Business
QSBS treatment is only available if the business uses a majority of its assets in connection with an active trade or business. Specifically, at least 80% of business assets must be used in the active conduct of business in any field, except for the following:
- The performance of services in health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, or financial/brokerage services
- Banking, insurance, financing, leasing, investing, or similar businesses
- Production or extraction of oil, gas, or other natural deposits
- Hotels, motels, restaurants, or similar businesses
- Any business where the principal asset is the reputation or skill of one or more employees
Stock within these excluded industries cannot qualify as QSBS. Research, experimental, and startup activities related to a future qualified trade or business generally qualify as active.2
It can be tricky if a business straddles a qualifying activity and a nonqualifying activity, such as technology and financial services (fintech) or manufacturing and healthcare. In these situations, to determine whether the business qualifies as QSBS or not, Internal Revenue Service (IRS) guidance indicates that the following factors should be considered:
- Where does the company derive most of its revenues – from the qualifying or nonqualifying activity? For example, are customers paying for a personal service (like healthcare, which would not qualify) or a manufactured product (like a medical device or tangible product)?
- Are most of the company’s employees involved in the qualifying activity or the nonqualifying activity?
- Is the company’s uniqueness or success dependent on a qualifying or nonqualifying activity? For example, if the company’s unique differentiating factor is its amazing technology platform, that would help lead to the conclusion that the company is predominantly a technology company that could qualify for QSBS.
- Other factors to consider include:
- Are the qualifying and nonqualifying activities conducted in separate legal entities? If yes, do the entities file a single consolidated tax return?
- Are 80% or more of the company’s assets used for the qualifying or nonqualifying activity?
Shareholders and founders of businesses in sectors like fintech or healthcare tech that straddle a qualifying activity and a nonqualifying activity might consider seeking a tax or legal opinion from a QSBS expert such as an attorney or other qualified tax advisor. Professional guidance may protect from penalties on any tax liability in the event the IRS disagrees with the position that the business’s activity qualifies for QSBS treatment.
The Shareholder Must Elect QSBS Treatment on Tax Return
Although the remaining QSBS qualifications are complex, the mechanics of making the QSBS election are relatively simple. A shareholder can make a QSBS election on Schedule D of her tax return.
Sufficient proof that the shares qualify as QSBS should be obtained from the business and retained for a minimum of three years following the filing of the relevant tax return in case the IRS audits and questions whether the stock qualified as QSBS. It is much harder to create a paper trail when/if the IRS questions the return – which would likely occur years after the company has been sold – than to be proactive and document QSBS qualification at the time of sale.
Restrictions on QSBS
Now, we get to the bad news. Under current law, the maximum amount a shareholder can exclude from taxable gain on a sale of QSBS is the greater of 10 times the shareholder’s basis in the shares or $10 million.
Many startup entrepreneurs, especially those in the tech sector, have invested a tremendous amount of time and talent into their businesses but have only invested limited financial or capital assets and have very little basis in their shares. In these common situations, the founder or shareholder could sell up to $10 million of QSBS completely income tax-free.
Please note that these rules and limits apply on a per-issuer (corporation) basis. In essence, the shareholder gets the greater of 10 times basis or $10 million (subject to any additional caps) for each company that meets the definition of a qualified small business. For example, if the shareholder owns QSBS in three different companies, he can reap the tax benefits of the QSBS exclusion three separate times.
Under current law, the $10 million (or 10 times basis) exclusion is cut if the shareholder acquired the shares before September 28, 2010. For shares acquired before February 18, 2009, up to 50% of the shareholder’s total gain may be excluded from tax. Finally, if the shareholder acquired the shares between February 18, 2009, and September 27, 2010, up to 75% of her total gain may be excluded from tax.
|QSBS Exclusion Percentage, by Acquisition Date|
|Date Acquired||Exclusion %|
|On or after September 28, 2020||$10 million (or 10 times basis)|
|September 27, 2020-February 18, 2009||75%|
|On or before February 17, 2009||50%|