Section 1202 of the Internal Revenue Code (IRC) provides tax benefits for qualified small business stock (QSBS). This tax break was designed to encourage investment in small businesses by reducing capital gains taxes.
QSBS can be eligible for a capital gains exclusion of up to 100%. However, specific requirements must be met to qualify for this exclusion.
QSBS Requirements
First, a Qualified Small Business must be an active C Corp (not an S Corp) incorporated in the United States, with less than $50 million in gross assets before and after the stock is issued. A QSBS is any stock acquired from a QSB after August 10, 1993, when Section 1202 was originally enacted.
There are also a few industries that are not eligible for QSBS status. These include the broad group of “services” or any business where the principal asset is the reputation or skill of its employees. QSBS does, however, include investments in technology, research and development, and manufacturing. Some states don’t offer QSBS exclusion at the state level, including California, Mississippi, Alabama, Pennsylvania, New Jersey, and Puerto Rico.
To qualify for the QSBS tax benefit, shares must be purchased at the original issue (not on the secondary market) and held for at least five years. Additionally, the investor cannot be a corporation, and the stock must be acquired with cash or property or as compensation for services.
Finally, at least 80% of the company’s assets must be used in the active conduct of one or more qualified trades or businesses.
QSBS Benefits
Section 1202’s Small Business Stock Capital Gains Exclusion describes the tax benefit in detail. In general, the benefit allows non-corporate investors to exclude a portion of the gain from selling QSBS as long as specific requirements are met.
The amount of gain that can be excluded depends on when the QSBS was acquired. For QSBS acquired between August 11, 1993, and February 17, 2009, the exclusion is 50%, and 7% of the excluded gain is subject to alternative minimum tax (AMT).
For QSBS acquired between February 18, 2009, and September 27, 2010, the exclusion is increased to 75%, but 7% of the excluded gain is still subject to AMT.
Finally, for QSBS acquired after September 27, 2010, the exclusion is 100%, including gain excluded from AMT and net investment income tax (NII).
Meanwhile, there are limits on the total amount of gain that can be excluded. The federal government currently allows for a $10 million cumulative limit and an annual limit of 10 times the basis of QSBS sold during the year.
Importantly, taxpayers can claim the entire excluded amount in one year or spread it out over multiple years.
QSBS Example
For example, consider a single investor with an ordinary taxable income of $500,000. This puts them in the highest tax bracket for capital gains, which is currently 20%. Assume they sell qualified small business stock, purchased in 2011, five years later, with a realized profit of $100,000.
Typically, this gain would be subject to a capital gains tax of $20,000. However, because the stock qualifies for the best QSBS treatment, the investor can exclude 100% of their capital gain.
This only applies if all the guidelines mentioned above are met. For instance, if that investor was in California, they would not qualify for QSBS status and would instead be subject to state capital gains taxes.
The bottom line is that QSBS can offer tax benefits for investors, but it’s essential to be aware of the requirements and consult with a tax advisor to be sure your situation qualifies.