Breaking the Code: Qualified Small Business Stock Exclusion
By: Rachel Speigle Dunnigan, CPA, MSA
If you periodically support small businesses by investment, you may be eligible for a tax break that has, until recently, been relatively unfamiliar to most taxpayers. Also known as Section 1202, this creates opportunities for individuals to exclude up to 100 percent of the gain on sale or exchange of Qualified Small Business Stock (QSBS) from their income.
In order to qualify for this potential exclusion, the Qualified Small Business must meet a few rules.
Active Business Test
The corporation must have at least 80% of its assets involved in active conduct of qualified trade or business. While the IRS does not have a strict definition of what type of businesses do qualify, they provide examples of businesses that do not qualify. These include real estate investment trusts, regulated investment companies, services in the health, law, engineering, architecture, or accounting fields, and hotel or restaurant businesses, among others.
C Corporation
The corporation must be a domestic C Corporation with stock issued after August 10, 1993. In order to qualify for the exclusion, the stock is required to be acquired directly at original issue. The QSBS itself can be held by an individual or through a partnership.
$50 Million in Assets
In order to be a Qualified Small Business, the business must actually be small. The corporation’s assets cannot exceed $50 million before and directly after the stock is issued. This potential exclusion is available at the Federal level but may need to be reviewed for possible state gain exclusion as the treatment varies by state.
Time and Date Restraints
Any QSBS must be held for at least five years before selling to potentially exclude gains on the sale. There are some options for reinvesting the proceeds of the stock if the stock is not held for five years, but we will assess this on a case by case basis. Additionally, there are exclusion waves from when the stock was acquired: If acquired on or before Feb. 17, 2009, only 50% of the gain may be excluded. If acquired on or between Feb. 18, 2009 and September 27, 2010, only 75% of the gain may be excluded. Any acquisitions after September 28, 2010 are eligible for 100% gain exclusion.
You might be thinking – why haven’t I heard of this before?! The original law was not permanent and the five year required holding period had not yet been realized (based on the first tranche of eligibility) so many individuals dismissed the exclusion. After many amendments and updates in recent years, the gain exclusion has become much more favorable and prominent. Additionally, prior to the Tax Cuts and Jobs Act of 2017, the Alternative Minimum Tax minimized the overall benefit of the gain exclusion.
If you believe that you may have some stock that could qualify as QSBS, please reach out and we’ll be happy to look at your individual tax situation.
To ensure compliance with the requirements imposed on us by IRS Circular 230, we inform you that any tax advice contained in this communication (including any attachments) is not intended to and cannot be used for the purpose of: (i) avoiding tax-related penalties under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any tax-related matter(s) addressed herein.