Selling shares in a business completely (or partially) income tax-free sounds too good to be true, right? Perhaps not. To the delight of many an owner, if certain qualifications are met, shares in a C corporation may be sold completely or partially income tax-free.
The secret is qualified small business stock (QSBS). QSBS is originally issued stock held more than five years in an active C corporation with less than $50 million of assets. An individual, trust, estate or other non-corporate taxpayer that owns QSBS may exclude all or a portion of the gain from a sale of those shares from federal income taxes. State rules vary, but the vast majority recognize the QSBS election and allow sales of such stock to escape (in whole or part) state income tax as well.
Because the QSBS exclusion can allow for a sale of certain businesses tax-free, it is no wonder the designation has surged in popularity over the past few years. Every business owner selling C corporation shares should walk through the QSBS requirements to see if they are met, as millions of tax dollars could be saved. In this article, we cover six requirements for QSBS treatment. Even if all are not met, read on, as there may be an alternative or workaround.
Only a Certain Amount of Gain Can Be Excluded (But It Could Be a Big Number)
To break the suspense, we begin with the rules regarding the maximum gain that can be tax-free if the QSBS requirements are met. 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. There are some important dates to keep in mind, too, as the QSBS rules have changed twice over the past 10 years, and different rules apply depending on when the shares were acquired. If the shares were acquired before September 28, 2010, there may be an additional cap. For those 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.
For example, if Sam acquires QSBS in December 2010 for $2 million and sells it in December 2017 for $20 million, 100% of his $18 million gain will be federal income tax-free, assuming all other QSBS requirements are met. Because he acquired the stock after September 27, 2010, Sam can exclude 100% of the gain subject to the rule that only the greater of $10 million or 10 times basis can be excluded. Ten times Sam’s $2 million basis is $20 million, making that the maximum amount of gain he can exclude if the requirements are met. Since his gain is only $18 million, the whole $18 million gain is excluded from federal income tax. If, instead, Sam acquires the QSBS in December 2008, just 50% of his gain ($9 million) can be excluded from tax under the QSBS rules.
Note also 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 qualifying as a qualified small business (QSB). For example, if the shareholder owns QSBS in three different companies, he can reap the benefits of the QSBS exclusion three separate times.
It is also important to note that any amount of gain excluded under the percentage limitations noted does not qualify for the 20% long-term capital gains tax rate and is instead taxed at a 28% capital gains rate. For example, if Sam only gets a $9 million exclusion from his $18 million gain for QSBS treatment of shares acquired in 2008, the remaining $9 million taxable gain will be taxed at a 28% capital gains tax rate.
Shares Must Be Held for More Than Five Years
To receive QSBS treatment, the 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 of the same company in a tax-free transaction, the holding period of stock received includes the holding period of the converted or exchanged stock. For example, the holding period of convertible preferred stock will be added to the common stock received on conversion. For shares received by gift or inheritance or as a transfer from a partnership, the holding period includes the period the donor, decedent or partnership held the stock.
Shares Must Be Acquired at Original Issuance
The QSBS must have been directly acquired after 1993 at original issuance from a U.S. C corporation or its underwriter in exchange for money, property or services.1 In other words, shares purchased on the secondary market are not qualified 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.2 The amount of assets the business has 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 the 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; farming; production or extraction of oil, gas or other natural deposits; hotels, motels, restaurants or similar businesses; and 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 as well as activities performed by specialized small business investment companies generally qualify as active. The following assets also can be counted as used in connection with an active trade or business: assets held for reasonable working capital needs and those held for investment that are expected to be used within two years to finance research, experimentation or additional reasonable working capital in a qualified trade or business.3 A business will fail the active trade or business test if it has too much portfolio stock or passive real estate. Specifically, no more than 10% of the value of the business’s assets (net of liabilities) can consist of real estate not used in connection with an active trade or business or of stock or securities in other corporations that are not subsidiaries of the business and not held as working capital.
The Shareholder Must Elect QSBS Treatment on His or Her Tax Return
Although the remaining QSBS qualifications are complex, fortunately 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.
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 a 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 that does not have a five-year holding period requirement. Non-corporate stockholders with shares held at least six months that otherwise qualify as QSBS should consider a rollover if there are other QSBs they find attractive for investment. The tax code allows the deferral of gain from a sale of QSBS held at least six months if the shareholder, within 60 days of the first QSBS sale, uses the proceeds to invest in other QSBS. The shareholder does not need to reinvest the entire sales proceeds, but only the amount reinvested in QSBS is not subject to tax. If the shareholder cannot or chooses not to pursue the QSBS exclusion, but instead decides to roll over just a portion of the sales proceeds, the amount not reinvested is subject to tax as if no QSBS election were made – thus, the 20% long-term capital gain rate may be available.
In the event of a rollover, both the tax basis and the holding period of the original QSBS transfer to the new one. Thus, when the second QSBS is sold, it is easier to meet the five-year holding period, as both the holding period of the first and second QSBS are aggregated. For example, consider Sam from the earlier example. Sam gets a $9 million exclusion from his $18 million gain for QSBS in Company A that he acquired in 2008. Sam could pay no income tax on half his shares, as it falls within the gain that qualifies as QSBS, and then reinvest the other half within 60 days into another QSB, Company B. Sam’s income tax basis in his Company B shares is the same as a proportional amount of basis in his Company A shares – $1 million. 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 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 among the stockholder and trust could get two QSBS exclusions. 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), the QSBS amount will be excluded from state income taxes.
Can pass-through entities such as S corporations and limited liability companies (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 it a C corporation, the stock held immediately after the termination will not be QSBS because it is not original issuance by a QSB. If the business starts as an LLC, then the company could be converted into a C corporation to qualify for QSBS in several ways, with a tax-free reorganization or taxable conversion being the most common. It should also be noted that if the C corporation converts to another type of entity at some point, QSBS is not automatically defeated. The business must only be a C corporation during substantially all of the taxpayer’s holding period.
One final word of advice: Be cautious when seeking to obtain QSBS benefits. The QSBS rules are still relatively new 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.