December 2, 2023

Qualified small business stock – or QSBS — The exemption outlined in Section 1202 of the Internal Revenue Code provides one of the most favorable capital gains tax breaks in the federal income tax law. However, in our experience, very few people take advantage of it. That’s unfortunate because the exemption provides entrepreneurs and investors with a way to sell stock and avoid paying federal income tax on all or some of their gains, depending on the acquisition date.

Many people do not take advantage of QSBS because they simply do not know or are confused about its application. This should change.

Bill Loftus

Bill Loftus, Founding Partner of Coastal Bridge Advisors.

The QSBS exemption was originally signed into law in 1993. Its purpose is twofold: to encourage increased investment in venture capital firms that have traditionally struggled to attract venture capital, and to create jobs in emerging industries. The exemption has been amended several times over the years, but the goal of accelerating the pace of investment in high-growth industries and rewarding founders and investors of qualified businesses has always remained the same.

how it works
The QSBS exemption eliminates federal income tax on capital gains of $10 million or 10 times the invested capital, up to a cap of $50 million. It also eliminated the 3.8% Medicare surtax of the same amount. Assuming a zero base, an individual could save up to $2.38 million for a gain of $10 million (assuming a long-term capital gains tax rate of 20%, plus a surcharge of 3.8%). Additionally, some states follow federal regulations that allow taxpayers to exempt state taxes as well.

However, there are specific guidelines that must be met in order to qualify for the exemption under the tax code. They include but are not limited to the following:

  • The company was formed as a domestic C corporation when the stock was issued.
  • Shares are purchased directly from a corporation by a taxpayer upon initial issue of currency, property (other than stocks) or services. Secondary stocks are not eligible.
  • At least 80% of the company’s assets must be used in a qualifying trade or business. Services, real estate and agriculture are not eligible.
  • Shares must be issued when the total value of the company is less than $50 million.
  • Shares must be held for at least five years. If the stock comes from stock options, the purchase date is the exercise date, not the vest date.
  • If a taxpayer exchanges QSBS for shares of another company in a Section 368 reorganization or certain Section 351 transactions, the new shares will generally be considered QSBS and the holding period of the original QSBS waived will be attached to the shares held. The deadline for receiving new items.
  • Hedging transactions may disqualify QSBS unless the taxpayer held the stock for five years prior to the transaction.

planning considerations
For new entities, consider forming a C Corporation. For existing LLCs valued under $50 million, consider converting to a C Corporation. Also consider starting as an LLC and transitioning to a C Corporation before the company’s fair market value reaches $50 million. Since the shelter is valued at $10 million or 10x FMV, it is possible to shelter $400 million if it was $40 million on the conversion/establishment date.

As the exemption applies to individual taxpayers, consider having multiple families/entities (such as trusts with separate tax file numbers) buying or acquiring shares from the issuer.

After the six-month holding period, Section 1045 allows the transfer of QSBS stock proceeds to another qualifying company within 60 days. Gains on existing sales are recognized only to the extent that they exceed the original investment.

If the shares were purchased or acquired at different time intervals, be aware of the time period and cost basis as these factors can greatly affect the exemption.