NOTE – This is part one of a two-part series. Part two will follow in July 2025.
Tax reform has been in the news this month, and much of the discussion of the new bill in Congress has centered around whether or not the provisions of the new bill ultimately help small businesses.
But what if I told you that there is a law—which has been on the books since 1993—that allows and actually encourages small business owners to grow their business, sell their stock, and pay little or no capital gains. This provision is intended to apply exclusively to small business owners, not to big shareholders of massive corporations.
It’s not too good to be true! It’s called Qualified Small Business Stock (QSBS).
What is Qualified Small Business Stock?
Simply put, QSBS is stock issued by a corporation where both the corporation and the shareholder satisfy certain tests.
To start with, QSBS stock applies to stock in “C” corporations only – not LLCs taxed as partnerships or disregarded entities and not corporations that have made an “S” election (but next month we will have options concerning those entities).
For the non-accountants reading this who might not know if you own a “C” corporation or an “S” corporation, a “C” corporation is a corporation that didn’t make any special federal income tax elections to be treated otherwise and is subject to federal corporate income taxes.
What Test Applies for Whether My Business May Issue Qualified Small Business Stock?
Section 1202 of the Internal Revenue Code (the “I.R.C.”) contains the provisions relating to QSBS requirements for both the issuing corporation as well as the applicable shareholder.
In order for a corporation to issue qualified small business stock, there is a two-prong test that the corporation must first satisfy.
- The corporation must have less than $50 million in assets (on a tax basis) both before and after issuing the stock, with limited exceptions. This means that shares issued by the corporation can only qualify for QSBS treatment if, at the time they are issued, the corporation still qualifies based on this asset test. Once the corporation passes the $50 million asset mark, future stock issued by the corporation won’t qualify for QSBS treatment. After all, the QSBS law is intended to encourage investment in (relatively) small businesses, not established businesses with significant assets and a long, proven track record.
- 80% of the corporation’s assets (by value) are used in a qualified trade or business, which generally means an “active” trade or business. If the biggest asset of your business is the reputation or skill of your employees (like a law firm, accounting firm, or other personal services enterprise), or in the holding/development of real estate, then the business likely is not a “qualified” trade or business and its stock can’t qualify for QSBS treatment. If, on the other hand, the business is a manufacturer, technology company, or a company that “creates” something from valuable assets other than the reputation or skill of its employees, then maybe it is an active trade or business. This is a bit of a murky test, and lawyers and accountants spend significant time reviewing the business and its assets to determine whether assets are used towards a qualifying trade or business.
After the corporation satisfies both prongs of this test, there may be further inquiry depending upon whether the corporation has multiple business lines.
If my Business Passes the Test, What Shareholders Can Receive Qualified Small Business Stock?
If you determine your business can issue qualified small business stock, only certain shareholders can receive QSBS:
- Only an original shareholder can receive the qualified small business stock. This means, with limited exceptions, QSBS cannot be purchased or transferred from another shareholder or a broker, and must be issued directly by the corporation to the shareholder.
- The original shareholder must be an individual, partnership, or S corporation. Where a partnership or S corporation holds the stock, the individual owners must have been partners/shareholders of the partnership or S corporation when the QSBS stock was issued.
- The stock must be held for a minimum of five years.
My Business Can Issue QSBS, and I Have Shareholders Who Can Receive QSBS. What Are the Benefits?
Holders of QSBS stock issued after September 27, 2010, can exclude up to 100% of the gains from the sale of QSBS stock for federal income tax purposes, totaling up to the greater of $10 million or 10 times their basis in the stock.
Let’s use some numbers to demonstrate what an impact QSBS can offer.
Scenario 1:
- Tim invests in a small business, Widget Corp, and contributes $10,000 in exchange for 50% of the stock, which qualifies as QSBS.
- Widget Corp takes off. After 7 years, Widget Corp is worth $20 million, and Tim sells his 50% of Widget Corp for $10 million
- Tim’s cost basis in the stock is only $10,000, so 10 times his basis would only be $100,000. Ordinarily, he might have to pay capital gains tax on the $9.9 million difference between the $100,000.00 cost basis and the $10 million sales price.
- However, since the QSBS regulations permit Tim to exclude the greater of $10 million or 10 times his basis ($100,000), Tim can exclude the entire $9.9 million capital gain on the sale of his stock.
- Tim gets to sell his stock for $10 million and pay no federal capital gains tax. Tim is happy.
Scenario 2:
- Tim invests in Widget Corp and contributes $2 million in exchange for 50% of the stock, which qualifies as QSBS.
- Widget Corp takes off. After 7 years, Widget Corp is worth $40 million, and Tim sells his 50% of Widget Corp for $20 million
- Tim’s cost basis in the stock is $2 million, so 10 times his basis would be $20 million.
- Ordinarily, Tim would have to pay capital gains tax on the $18 million difference between the $2 million cost basis and the $20 million sales price.
- However, since the QSBS regulations permit Tim to exclude the greater of $10 million or 10 times his basis ($20 million), Tim can exclude the entire $18 million capital gain on the sale of his stock.
- Tim just made $18,000,000 in tax-free gain from a $2,000,000 investment. Tim is ecstatic.
The Devil in the Details
One important note—The capital gains exclusion does not translate in the case of a sale of substantially all of a corporation’s assets and a resulting liquidation.
As such, owners of QSBS stock negotiating a sale of their business will almost always prefer to structure the transaction as a stock sale vs. an asset sale—even if that means lowering the purchase price a bit to account for the buyer’s loss of depreciation and other incremental tax benefits.
NEXT MONTH – How can I take advantage of QSBS if my entity is an LLC or “S Corporation”?
Are you starting a business? Selling a business? Contact attorney Tim Canney, chair of the business and tax group at Bulman Dunie, who can advise you about all issues relating to succession planning and tax strategies that a small business owner should know.
