Qualified Small Business Stock
Internal Revenue Code (IRC) § 1202 allows startup founders to avoid tax on the sale of “qualified small business stock” (QSBS). For high-growth startups, the potential tax savings can be huge—founders can save millions of dollars of taxes on a sale of QSBS.
Despite the potential tax savings that IRC § 1202 offers, many tax planners ignore it. Three main factors limit the usefulness of IRC § 1202:
- Five-Year Holding Period. For IRC § 1202 to work as a tax-planning strategy, the founder must hold the QSBS for five years and plan to sell the QSBS after the five-year period. Most founders cannot predict their business plan with that kind of
- Double Taxation. IRC § 1202 requires that the business by organized as a C corporation. Because C corporations are taxed twice on their income, they are the most tax-inefficient form of business. This puts founders in the position of having to decide whether the possibility of tax-free sale after five years is worth the certainty of double taxation on the business income.
- Shaky Assumptions. The benefits of QSBS depend on whether the stock initially qualifies as QSBS and continues to qualify as QSBS until it is sold. If any of IRC § 1202’s requirements are not satisfied, the entire plan fails.
But as explained in our discussion of the C Corp Startup Strategy, while IRC § 1202 may be a flawed standalone tax-planning strategy for most new businesses, it can provide a very attractive tax outcome for high-growth startups organized as C corporations to meet investor requirements. For these startups, IRC § 1202 presents significant tax-saving opportunities.
Benefits of Qualified Small Business Stock
IRC § 1202 excludes 100 percent of the gain on the sale of QSBS acquired after September 27, 2010. QSBS acquired between February 18, 2009, and September 27, 2018, qualifies for a 75 percent capital gains reduction, and QSBS acquired before February 18, 2019, qualifies for a 50 percent capital gains reduction.
The maximum amount that a founder can exclude is limited to the greater of $10 million or 10 times the founder’s base investment (basis) in the QSBS. If the founder paid less than $1 million for the QSBS, the $10 million limitation will produce the most savings. If the founder paid more than $1 million, the founder can multiply the amount paid by 10 to save even more. Note, however, that the $10 million cap is reduced to $5 million for married founders that file separately.
The IRC § 1202 exclusion comes with other tax-saving opportunities. Any amount excluded under IRC § 1202 also avoids the alternative minimum tax and the 3.8 percent Medicare tax. If the founder lives in a state that bases its income tax laws on federal law, the sale may also save state and local taxes on the sale. Taken together, these ancillary tax savings bolster the benefit of the IRC § 1202 exclusion.
What Business Entities Can Issue Qualified Small Business Stock?
To issue QSBS, the business must be organized as a C corporation. IRC § 1202 is unavailable to disregarded entities or pass-through entities like S corporations, partnerships, and LLCs taxed as S corporations or partnerships. Although the startup must be a C corporation, it cannot be:
- A domestic international sales corporation (DISC) or former DISC;
- A corporation that has filed an election to be treated as a corporation operating in a U.S. possession (usually Puerto Rico) under IRC § 936 (or which has a subsidiary that has elected to be treated as possessions corporation);
- A regulated investment company;
- A real estate investment trust or real estate mortgage conduit; or
- A cooperative.
The requirement that the business be organized as a C corporation means that IRC § 1202 is only available for founders that are willing to subject the startup to double taxation on all its income. And because the startup must remain as a C corporation during substantially all of the five-year holding period, the founders must continue to operate as a C corporation from the time that the QSBS is issued until the startup is sold.
What Types of Shareholders Can Own Qualified Small Business Stock?
Unlike the rules that apply to S corporations, QSBS does not have a maze of shareholder eligibility requirements. The only requirement is that the shareholder cannot be a C corporation. QSBS can be owned by S corporations, trusts, partnerships, and LLCs.
Special rules apply when pass-through entities own QSBS. When a pass-through entity sells QSBS, the gain from the sale passes through to the pass-through entity’s owners and is reported on their tax returns. The gain will be non-taxable under IRC § 1202 if the owner reporting the gain had an interest in the pass-through entity on the date that the pass-through entity acquired the QSBS and maintained an interest until the QSBS is sold. The gain limitations are applied separately for each of the pass-through entity’s owners.
How Must Founders Acquire Their Qualified Small Business Stock?
To qualify under IRC § 1202, founders must acquire QSBS from the issuing corporation in exchange for cash or other property or for services rendered to the corporation. The QSBS can be preferred stock or common and may or may not include voting rights. The startup can issue QSBS in multiple rounds, as long as the IRC § 1202 requirements are satisfied on each issuance.
Adequate documentation is important. Each founder that wants to qualify for tax-free treatment under IRC § 1202 should document the cash or property contributed to the corporation in exchange for the QSBS. This documentation can help provide a paper trail if the IRS questions whether the stock qualifies as QSBS.
To incentivize performance and reduce turnover, startups often give incentive stock options or non-qualified stock options. The startup may also issue warrants or convertible debt to other stakeholders. Each of these instruments allow the holder to purchase shares of the corporation at a predetermined exercise price. In each case, the determination of whether stock is QSBS is made when the holder exercises the option to purchase stock, not when the holder acquired the option to purchase the stock. The same is true for the holding period, which begins when the stock is actually issued and not when the holder acquired the purchase right.
Who Can Sell Qualified Small Business Stock in a Tax-Free Sale?
IRC § 1202 is not available for sellers that are not the original shareholders. For example, a person that buys stock from an original founder cannot later sell the stock in a tax-free sale under IRC § 1202. Tax-free treatment is only available to the person who originally acquired the QSBS from the corporation. There are exceptions for shareholders that acquire QSBS through gift (whether made during life or at death) or as a distribution from a pass-through entity.
How Long Must the Owner Hold Qualified Small Business Stock?
For a sale of QSBS to qualify for tax-free treatment under IRC § 1202, the shareholder must hold it for at least five years before the sale. This five-year holding period is QSBS’s biggest limitation. Any tax strategy that depends on QSBS status must assume that the shareholder will own the QSBS for at least five years and sell the QSBS before an event occurs that causes it to fail to qualify as QSBS.
For holders of options to buy QSBS, the five-year holding period begins when the QSBS is issued, not when the holder acquires the option. Similarly, if a service provider receives unvested shares of stock, the holding period begins when the vesting conditions lapse (when there is no “substantial risk of forfeiture” under IRC § 83) or when service provider files an IRC § 83(b) election.
Depending on the circumstances, IRC §§ 351 and 368 both provide for tax-free treatment on contributions of stock to a corporation in exchange for stock in that corporation. If the stock that the shareholder receives in the exchange is QSBS, IRC § 1202 allows shareholders to exchange QSBS for other QSBS in a tax-free contribution or reorganization under IRC § 351 or IRC § 368. In that case, the shareholder’s holding period relates back to the time that the exchanged QSBS was first issued. If the stock that the shareholder receives in the exchange or contribution is not QSBS, IRC § 1202(h)(4)(B) allows the shareholder to roll over the built-in gain from the old QSBS to the newly issued stock.
What is a Qualified Small Business?
For stock to qualify as QSBS, the issuing corporation’s aggregate gross assets must not exceed $50 million in value. The $50 million limitation applies to all the corporation’s assets, including assets that the shareholder contributes in exchange for the stock. For example, if a venture capitalist invests $40 million in return for stock in a corporation with $15 million in assets, the corporation’s stock will not qualify as QSBS since, after the contribution, the corporation’s assets exceed $50 million.
The $50 million limitation applies only when the QSBS is issued. If a corporation with assets worth less than $50 million issues stock that qualifies as QSBS, and the stock will retain its status as QSBS even if the corporation’s assets later exceed $50 million in value.
What is the “Active Business Requirement” for QSBS?
IRC § 1202 only applies to corporations that use at least 80 percent (measured by value) of their assets in the active conduct of one or more qualified trades or businesses. A qualified trade or business is any trade or business other than:
- any 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 one 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 IRC §§ 613 or 613A; and
- any business of operating a hotel, motel, restaurant, or similar business.
Most high-growth startups will have no trouble meeting the active business requirement. If there is a question about whether certain business activities would constitute a qualified trade or business, the startup may spin those activities to a brother-sister corporation to avoid the risk of disqualifying the stock.
Special rules apply to the corporation’s ownership of other corporations. These rules depend on whether the owned corporations are subsidiaries. For this classification, a corporation owned by another corporation is a subsidiary if the parent corporation owns more than 50 percent of the combined voting power of all classes of stock subject to vote or more than 50 percent of the value of all outstanding stock. If the corporation engages in business through a subsidiary, the subsidiary’s assets and business are generally treated as assets and business of the corporation. If more than 10 percent of the corporation’s assets consist of stock in corporations that are not subsidiaries, the corporation does not meet the active business requirement.
For the stock to retain its status as QSBS, the corporation must meet this active business requirement for substantially all of the period that the shareholder owns the stock. If the corporation uses at least 80 percent of its assets in the active conduct of a trade or business at the time the stock is issued, but later dips below this threshold, the stock may lose its status as QSBS. As a practical matter, this pressures shareholders to sell QSBS soon after the five-year holding period expires to avoid the risk of losing QSBS status.