If you are the founder of a start-up company, or have invested in one, you may have already heard about Qualified Small Business Stock (QSBS) and the gain exclusion available under IRS Code Section 1202. It has been a hot topic for investors and entrepreneurs for the last few years. The reason for the increased interest in this tax provision is the large tax savings available to taxpayers when selling shares of QSBS. In recent years Congress wanted to incentivize more investment in small businesses, so it has progressively increased the amount of gain exclusion.
What Sec. 1202 allows you to do, under specific conditions, is to exclude all or part of a gain from taxable income when selling QSBS. Up to $10 million or 10 times the basis in the stock can be excluded, whichever is larger. With a 20% federal capital gain rate, tax savings on a $10 million gain could amount to $2 million. And if the state in which you operate follows the federal tax treatment, like New York does, additional state tax savings will follow.
To qualify as QSBS, the stock has to meet the following conditions:
- It needs to be stock in a domestic C corporation. Shares in S corporations, interests in partnerships, and LLCs do not qualify. It is possible to convert an LLC to C corporation and benefit from this provision.
- The shares must have been issued after August 10, 1993.
- The shares must be acquired at its original issue (not from a secondary market).
- The company must meet the definition of a small business (i.e., total gross asset at all times before the date the shares are acquired must be less than $50 million).
- The company must be engaged in active trade or business; some industries are excluded.
The amount of gain eligible for exclusion depends on when you acquired the QSBS shares.
- Stock acquired between 8/11/93 and 2/17/09 is eligible for 50% gain exclusion, subject to a 7% AMT addback.
- Stock acquired between 2/18/09 and 9/27/10 is eligible for 75% gain exclusion, subject to a 7% AMT addback.
- Stock acquired after 9/28/10 is eligible for 100% gain exclusion without any AMT addback.
The taxpayer needs to hold the shares for at least five years from the date he or she acquired them (if shares are from stock options, the acquisition date is the exercise date, not the date of grant).
QSBS treatment can provide significant tax savings to investors. In addition to the benefits available under Section 1202, there are other sections which may provide benefits as well, including Section 1045 for the rollover of gain from one QSBS to another. If you are planning to invest in small businesses—including technology start-ups—a qualified tax accountant can help you learn how to use QSBS to your advantage.