Companies often seek equity financing to help fund their business from a variety of investors who seek to generate a sizable return on their investment. Section 1202 stock, otherwise known as Qualified Small Business Stock (QSBS). QSBS, is an attractive type of equity investment certain small businesses can offer due to the potentially significant tax benefits it can provide to its holders. In general, gain from the sale or exchange of QSBS held for more than 5 years provides a taxpayer an opportunity to realize up to $10 million in federal tax-free gains.
What is Qualified Small Business Stock?
Pursuant to Section 1202 of the internal revenue code, “qualified small business stock” means any stock in a C-Corporation which is originally issued after the date of enactment of the Revenue Reconciliation Act of 1993 if (A) as of the date of issuance, such corporation is a qualified small business and (B) such stock is acquired by the tax payer at its original issue (directly or through an underwriter) (i) in exchange for money or other property (not including stock), or (ii) as compensation for services provided to such corporation (other than underwriting services of such stock). There are a couple exclusions to requirement (B) above in the case of a conversion of an entity, a transfer from a pass-through entity and a transfer due to gift or death.
What are the Qualifications for Small Business Stock?
As discussed above, one of the requirements is that a corporation must be a qualified small business, which means:
- The company must be a domestic C-Corporation. Stock of any other type of entity (including an S-Corp) will not qualify.
- The aggregate gross assets of the company may not exceed, whether in the past or immediately after issuance of stock, $50 million dollars (for this purpose, the term “aggregate gross assets” means the amount of cash and the aggregated adjusted bases of other property held by the corporation).
- At least 80% of the assets of such corporation are used in the active conduct of one or more qualified trades or businesses for the five year holding period which a taxpayer must hold such stock. A “qualified trade or businesses” means any trade or business other than:
- Trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees;
- Any banking, insurance, financing, leasing, investing or similar business;
- Any farming business (including the business of raising or harvesting trees);
- Any business involving the production or extraction of products of a character with respect to which a deduction is allowable under Section 613 of the Code (i.e., mines, wells and other natural deposits); and
- Any business of operating a hotel, motel, restaurant or similar business.
- The corporation must be a qualified small business on the date the stock is issued.
- The stock must be held for a minimum holding period of 5 years.
Why is QSBS important to Small Business Owners and Investors?
QSBS provides an incentive to encourage taxpayers to invest in small business and provides investors a change to realize as much as $10 million dollars of federal tax-free gains. The following are the main benefits associated with QSBS.
Excludable Capital Gains
The most common benefit of holding QSBS is an ability to exclude from federal tax liability up to $10 million dollars. This can result in significant tax benefits, as an investor with the full $10 million dollars to be excluded would save around $2.38 million in federal tax liability (assuming 20% long term capital gains rate tax and a 3.8% for net investment income tax rate). It is best to consult with a tax expert and a CPA to see how QSBS can help reduce your investors tax liability.
Gift Qualifying Upon Sale of Stock
Section 1202 states that each non-corporate taxpayer is entitled to their own gain exclusion for QSBS stock they own. Gifted QSBS carry with them the attributes of QSBS (including the holding period and carryover cost basis), which provides an incentive for certain taxpayers to gift away QSBS upon a sale to help spread tax benefits. For example, if a taxpayer sold their QSBS and was to incur a $20 million capital gain, such taxpayer could gift half of the shares to a child (perhaps through an estate planning mechanism such as a trust), and then both the original taxpayer and the child could each have their own $10 million exclusion, therefore each saving them $2.38 million in tax liability. However, be aware that taxpayers are still required to comply with the lifetime gift and tax rules (currently the lifetime gift and estate tax exemption is $11.7 million, so in the above example, $10 million of such lifetime exemption would be used up). This is something individuals need to keep in mind when talking with their estate planning and tax attorneys.
Potential State Tax Savings
Certain states also provide for such gains to be exempt from taxes at the state level. This is true if the taxpayer can establish residency in a state that has either (1) no income tax, (2) no capital gains tax, or (3) confirms to the federal treatment for QSBS. Most states allow for this tax-free treatment with some exceptions.
Contact Our Team For Assistance
While the above is a summary of the qualifications and benefits of using QSBS provided to small businesses and investors, it is crucial to consult with legal counsel in order to make sure your business is qualified in order to help reap these benefits.
If you’re looking for a strategic partner to help achieve your fundraising and business goals, contact us today.