Who wouldn’t love to sell their business, or a successful angel investment, totally income tax-free? If selling tax-free sounds good to you, 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 when the investment was made. Limited liability companies (LLCs), S corporations and partnerships won’t qualify – although read on, as some of these entities can be converted to qualify. Typically, QSBS companies 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 exemption 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
To receive QSBS treatment, shares must be held for at least five years from the date they are acquired to the date they are sold. 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
The QSBS must have been acquired after 1993, directly from a U.S. C corporation or its underwriter, in exchange for money, property or services. In other words, shares purchased on the secondary market are not QSBS. To prevent corporations from simply redeeming shares and reissuing stock at original issuance to qualify it as QSBS, rules provide that QSBS treatment may be unavailable if certain redemptions occurred within a specific time period before the selling shareholder received his or her shares. If the shares were acquired 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 QSBS election was created 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 business will also be deemed to own a proportionate amount of the assets and to perform 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 a majority of the business’s assets are used in connection with an active trade or business. Specifically, at least 80% of the 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 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, guidance from the IRS indicates that the following factors should be considered:
- Where does the company derive most of its revenues – from the qualifying activity or the nonqualifying activity? For example, are customers paying for a personal service (like healthcare, which would not qualify) or a product that is manufactured (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 here are:
- 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 CPA, which may protect from tax penalties 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 QSBS election is made on Schedule D of the shareholder’s 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.
One final word of advice: Be cautious when seeking to obtain QSBS benefits. The QSBS rules are sparse and leave many open questions. Advice specific to a shareholder’s unique situation is essential. Meeting the QSBS requirements is generally an all-or-nothing proposition. If the stock does not qualify as QSBS, then the potentially generous provisions to exclude gain are wholly unavailable. Brown Brothers Harriman’s Wealth Planning team is well versed in these complexities and would be happy to discuss your personal situation with you and your advisors.
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 capital 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, so 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 benefits of the QSBS exclusion three separate times.
Under current law, the $10 million (or 10 times basis) exclusion is cut if the shares were acquired 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 shares were acquired between February 18, 2009, and September 27, 2010, up to 75% of the shareholder’s total gain may be excluded from tax.
In 2021, a Congressional proposal – the Build Back Better Act, which was not passed by the Senate, but did pass in the U.S. House of Representatives – sought to limit all QSBS sold after September 14, 2021, to a 50% maximum exclusion of gain. Although no similar legislation has been introduced since, it is possible that similar limits on QSBS could be enacted in the future.
How bad really are these limits? How does this 50% cap (that currently applies only to shares acquired before February 18, 2009) on QSBS work? The 50% cap on QSBS is worse than it would seem at first blush. Sadly, it is not as simple as applying the 20% long-term capital gains tax rate to 50% of the gain and a 0% rate (the excluded rate for QSBS gains) to the other 50% of the gain, giving you a total blended rate of a modest 10%. Instead, 50% of the gain that would otherwise be excluded but for the cap is taxed at a higher 28% capital gains rate. In addition, 7% of the QSBS excluded gain is subject to a 28% tax (because it is a preference item for purposes of the alternative minimum tax). On top of this higher 28% tax rate, the 3.8% net investment income tax applies to the realized gain on the sale of stock (except what ends up being excluded). These rules are extremely dense, so some examples are necessary:
Assume Sam Founder sells $10 million of QSBS acquired in 2008, which is a year when a 50% cap applies, or assume the law changes to put a 50% cap on all QSBS sales. Next, let’s assume Sam has practically $0 basis in his shares. Sam is only allowed to exclude 50%, or $5 million of gain on the sale of his shares. However, the other $5 million isn’t subject to the 20% capital gains tax rate. Instead, it is subject to a higher 28% tax rate, plus the 3.8% net investment income tax, and 7% of the other $5 million that nearly avoids tax is also subject to the 28% tax rate. Ignoring state income tax, this leaves Sam with a tax bill of $1.688 million – basically, a 16.88% effective tax rate on the entire $10 million of sale proceeds. The QSBS exclusion in this example is only worth $312,000. And poor Sam may have paid double tax on the profits of his business during its entire operation! Let’s compare this tax rate with what Sam would have paid had he started his business as an LLC and sold shares in the LLC. An LLC does not qualify for QSBS, but unlike a C corporation, an LLC does not tax the profits distributed to its owners twice. If Sam had an LLC instead, he would pay a 20% capital gains tax rate on most of his gain – $2 million of tax on the sale of his business for $10 million.
Let’s now increase Sam’s gain to $100 million and continue to assume a 50% cap applies to the sale of his shares as well as all other facts in the prior example. The maximum QSBS gain is $10 million. We can only exclude 50% of that $10 million QSBS eligible gain. On this $10 million, $5 million gets taxed at the 28% tax rate, and the other $5 million escapes tax except for a small alternative minimum tax, which basically taxes 7% of the $5 million at the 28% rate. The remaining $90 million is subject to the 20% long-term capital gains tax rate, and $95 million is subject to the 3.8% net investment income tax.
Let’s now minimize Sam’s gain, just to hammer home how challenging the 50% cap is for owners of QSBS. Let’s say Sam’s total gain is only $5 million. Despite the fact that but for the 50% cap you could escape tax on $10 million, Sam doesn’t get $5 million tax-free. Instead, we cut his $5 million gain in half, and he pays 28%, as well as a 3.8% net investment income tax, on $2.5 million. The other $2.5 million nearly escapes tax altogether – except for the pesky alternative minimum tax, which subjects 7% of the other $2.5 million to a 28% rate. All in, Sam pays $844,000 of tax, exactly one-half of the tax he pays in the first example, where he sells $10 million of QSBS. Sam is subject to the same 16.88% tax rate as in the first example.
If these rules still seem dense, remember the following two rules of thumb in a world where a 50% QSBS cap applies. First, for a founder or investor with little basis in his shares (less than $1 million), no more than $5 million of gain per taxpayer could ever be excluded under QSBS. Second, it is safe to assume that an approximately 16.88% effective federal tax rate applies to the first $10 million (or, if basis is higher, whatever total amount you could have excluded but for the 50% cap) of QSBS gain, and amounts in excess of this QSBS gain are subject to the 20% long-term capital gains rate plus a 3.8% net investment income tax.
Frequently Asked Questions
If the stock has not been held for five years but otherwise meets the QSBS requirements, are there any other opportunities to reduce or defer income tax on the sale of the shares?
Many people have heard of 1031 exchanges, where real property is exchanged tax-free for like-kind real property. There is a similar provision for QSBS under section 1045 of the Internal Revenue Code, whereby sale proceeds on QSBS that exceeds applicable QSBS maximums, or stock that does not meet the five-year holding period requirement, can be exchanged for new QSBS. The tax code allows the deferral of gain from the sale of the old QSBS if the new QSBS is held at least six months and if the shareholder purchases the new QSBS within 60 days of the sale of the old QSBS. The shareholder does not need to reinvest the entire sale proceeds.
In the event of a rollover, both the tax basis and the holding period of the original QSBS transfer to the new QSBS. Thus, when the second QSBS is actually sold, it is easier to meet the five-year holding period, as both the holding period of the first and second QSBS are aggregated.
Let’s return to Sam from the earlier example. Sam gets a $5 million exclusion from his $10 million gain for QSBS in Company A that he acquired in 2008. Sam could pay practically no income tax on half of his shares (other than the 7% described earlier) and then reinvest the other half ($5 million) within 60 days into another QSBS, shares in Company B. Under the QSBS rules, Sam is deemed to have acquired his Company B shares in 2008. Thus, he meets the five-year holding period immediately, since this timeframe includes the holding period of his Company A shares. If Company B is sold shortly after Sam’s investment, Sam could take another QSBS exclusion on the Company B shares and have a second sale with a partially tax-free gain.
As recommended by my advisors, I gave away a portion of the shares in my business to an irrevocable trust that will not be taxed in my estate. I own half the shares, and the trust owns half the shares. How will the QSBS exclusion be calculated between my and the trust’s shares?
It depends whether the irrevocable trust is a separate taxpayer. Some trusts are grantor trusts, meaning that they are subject to income tax on the trust creator’s income tax return. In this case, the shares held by the stockholder and trust will receive one QSBS exclusion, since the shares are aggregated for income tax purposes. Non-grantor trusts, on the other hand, are wholly separate taxpayers and file their own income tax returns. The QSBS rules provide that each taxpayer gets its own QSBS exclusion at the greater of $10 million or 10 times basis (subject to a 50% or 75% cap if acquired before September 28, 2010). As such, if the trust is a non-grantor trust (or is timely converted to a non-grantor trust), the QSBS shares owned by the stockholder and trust could each receive a QSBS exclusion. If a stockholder had three non-grantor trusts (and a substantive reason for having three), he or she could presumably get three QSBS exclusions.
What about state income taxes? Are QSBS gains excluded from those as well?
Unless a stockholder lives in one of the five states that do not recognize QSBS treatment (Alabama, California, Mississippi, Pennsylvania and Wisconsin), a valid QSBS election should also allow the QSBS amount to be excluded from state income taxes. A few other states (Massachusetts and New Jersey, for example) have QSBS requirements that do not mirror the federal requirements discussed above. Be sure to obtain advice specific to your state of residence.
Can passthrough entities such as S corporations and LLCs convert to C corporations to become eligible for QSBS treatment?
Whether another type of entity can convert to a C corporation to get QSBS treatment depends on what kind of entity it is. If the business starts as an S corporation and later terminates the S election, thus making the corporation a C corporation, the stock held immediately after the termination will probably not be QSBS because it is not original issuance by a QSB – one requirement of which is C corporation status. If the business starts as an LLC, then the company could be converted into a C corporation to qualify for QSBS in a number of ways, with a tax-free reorganization or taxable conversion being the most common. In the event of such conversion, the business must only be a C corporation during “substantially all” of the taxpayer’s holding period.