Qualified Small Business Stock (QSBS) exclusions for tax purposes under Section 1202 incentivize investors to take risks on startup companies. A shareholder with QSBS could potentially be eligible for a 100% tax exclusion on capital gains. For a shareholder’s stock to be considered QSBS, the company in which they own the stock must be a qualified small business (QSB). For a business to be considered a QSB, it must meet the following:
- The company must be an active U.S. C-corporation.
- The company must have had gross assets of $50 million or less at all times before and immediately after the equity was issued.
- At least 80% of the company’s assets must be actively used in a qualified trade or business.
- The company cannot perform services related to health, law, accounting, engineering, consulting, banking, or certain other fields as defined by the Internal Revenue Service.
Now that we know the requirements to be considered a qualified small business (QSB), it is important to know the requirements for the shareholders to be eligible for the QSBS exclusion. A shareholder must hold their QSBS-eligible stock for five years to qualify for the exclusion; this five-year period begins when shares are exercised and converted. If QSBS-eligible stock is sold before the five-year holding period, no benefit will be received, and the shareholder will pay either the short-term or long-term capital gains rate on their gain. There is a cap on how much of an exclusion a shareholder can receive. The cap is $10 million or 10 times the cost basis of their initial investment. For example, if a shareholder’s initial investment was $6 million in an eligible QSB, they could avoid paying capital gains tax on up to $60 million if they held the stock for at least five years.
While the QSBS exclusion is available on the federal return, it is important to note that a few states do not allow it. These states include Alabama, California, Mississippi, New Jersey, and Pennsylvania.
The exclusion discussed above is certainly a viable option for a shareholder’s QSBS, however there is also a way to defer the gain on the sale of QSBS even if the stock was not held for five years. This is called a Section 1045 rollover. To meet the Section 1045 rollover requirements, the following must take place:
- The original QSBS must be held for at least six months before it is sold.
- When the original QSBS is sold, the proceeds must be used to purchase another QSBS-eligible stock within sixty days of the sale date.
If these requirements are met, the shareholder can defer the gain from the sale of the original QSBS to the extent the sale proceeds do not exceed the purchase price of the newly purchased QSBS. The deferred gain will reduce the basis of the newly purchased QSBS.
Please reach out to your Sciarabba Walker contact or email us at info@swcllp.com if you have any additional questions.