The Qualified Small Business Stock (or “QSBS”) Exclusion, as it is more often known, was created by the Revenue Reconciliation Act of 1993 under Section 1202 of the Tax Code to encourage investment in American small businesses. The Small Business Jobs Act of 2010 substantially extended its first partial tax exclusion, making it a substantial advantage for entrepreneurs, staff members, early investors, and individuals making private investments. Determining if you can qualify for significant federal tax savings requires an understanding of the advantages of QSBS, its eligibility, and the numerous factors.

Up to a maximum of $10M or 10x the adjusted basis of the QSBS sold, a taxpayer may be able to exclude the gain from the sale of QSBS from capital gains tax treatment. Depending on when the QSBS was issued, the excludable gain percentage will change.

• QSBS acquired after September 27, 2010 will be fully exempt from both the Net Investment Income Tax and the Alternative Minimum Tax, with 100% of the capital gains excluded. 75% of the capital gains on QSBS acquired between February 18, 2009, and September 27, 2010 will be excluded; however, 7% of the excluded gain will be subject to Alternative Minimum Tax treatment.

• 50% of the capital gains on QSBS purchased between August 11, 1993, and February 17, 2009, will be excluded; however, 7% of the excluded gain will be subject to alternative minimum tax treatment.

• The QSBS gain exclusion is not applicable to stock that was issued prior to August 11, 1993.

This is not only a sizable tax benefit; each taxpayer is subject to the limit, which creates planning opportunities like holding QSBS in a variety of eligible entities and non-grantor trusts. Example: Sara contributed $2 million to a fledgling company in 2012. Since the investment was profitable, she chose to sell her shares in 2021 for a total of $19 million. It was concluded that her shares qualified for the §1202 QSBS Exclusion after speaking with her tax advisors and acquiring the required paperwork. Sara will be able to deduct her entire gain from capital gains taxes because his $17 million gain is less than the $20 million limit (10 times her $2 million basis in the shares she sold). She would have paid about 3.8% Net Investment Income Tax and the 20% Federal Capital Gains Tax if this benefit hadn’t been provided.

Corporate-Level Qualifications:

Size of Entity: The entity’s gross assets had to be $50 million or less both prior to and right after the stock was issued. According to this definition, cash and the total adjusted basis of the corporation’s other holdings are considered gross assets. A 409A Valuation is frequently supplied by businesses as supporting documentation.

Type of Business: 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 are examples of activities that are not permitted for eligible entities to engage in.

Organisational Framework: When starting a new company, entrepreneurs must first consider the benefits and drawbacks of different entity forms, including partnerships, LLCs, C Corps, S Corps, and sole proprietorships. Because they are less expensive to operate and are simpler to form, limited liability companies (LLCs) have become the preferred choice in recent years. A recent study found that LLCs were the most popular structure, accounting for 35% of newly formed businesses. That being said, only C Corps are qualified for the QSBS Exclusion at this time. Interestingly, there is a bill in Congress right now that allows S Corps to be eligible as well.

Stock requirements : The QSBS Exclusion is limited to equities. Debt, options, and warrants held by an otherwise qualified entity would not be accepted. Only a timely §83(b) election* by the recipient will qualify non-vested stocks.

*An 83(b) election allows an individual to accelerate the date on which restricted shares are subject to ordinary income taxes, and potentially pay a lower tax now versus a higher tax in the future. A founder or an employee of a startup who receives restricted stock has 30 days to file an 83(b) election .

Shareholder-Level Qualifications:

Type of shareholder : Individuals, trusts, estates, partnerships, LLCs, and S Corps are among the eligible shareholders. Planning opportunities now arise because of the application of the exclusion limitation per taxpayer. A QSBS is not available for C Corps to possess.

Duration of Holding : For the QSBS stock to be eligible for the exclusion, it must be held for a minimum of five years. The holding period normally starts when the stock is issued, but certain transactions may make things more difficult. For instance, a stock gift, inheritance, or distribution from a partnership will carry over its holding period to the new owner. On the other hand, corporate reorganisations such as recapitalizations could have a negative impact on the QSBS status. Notably, pursuant to §1045, the proceeds of the otherwise eligible QSBS may be rolled over into another QSBS within 60 days if the shareholder sells the position and the 5-year period is not fulfilled.

Original Issuance : Instead of purchasing the stock through the secondary market, the eligible shareholder must have obtained it through the original issuance. This requirement is not applicable in situations where the stock is distributed from a partnership, gifted, or inherited.

The Qualified Small Business Stock Exclusion could result in a sizable tax benefit. Eligibility, restrictions, and acquiring the necessary supporting documentation can frequently be a tangled processes.For optimum savings,we provide individualised, strategic planning based on the particular circumstances of each client.We keep up with regulatory changes so that our clients can adjust their strategies and stay compliant.