Do you own stock in a small business or startup company? If so, it’s possible the stock is eligible for Qualified Small Business Stock (QSBS) tax treatment, which can potentially save millions of dollars in capital gains taxes. In this article, we provide an overview of the QSBS rules and some planning opportunities to consider.
Under Section 1202 of the Internal Revenue Code, part or all of the gain from sale of small business stock can be excluded from taxable income if the business issuing the stock meets the following requirements:
- Domestic C corporation established after August 10, 1993
- Gross assets of $50 million or less at all times up to the time of issuance and immediately thereafter
- Active business, with at least 80% of assets being used to conduct a “qualified trade or business.” This definition excludes the following types of businesses:
- Service businesses where the skill or reputation of its employees is considered its primary asset (health, law, architecture, financial services, etc.)
- Banking, insurance, financing, or leasing businesses
- Production or extraction of products, such as wells, mines, and natural deposits
- Restaurant and hospitality businesses
- Additional requirements apply if the corporation owns real estate not used in the active conduct of trade or business, or if the company has made redemptions within two years before or after issuing the stock.
Please note that the stock needs to have been purchased directly from the corporation (i.e., not from an existing shareholder), and held at least five (5) years in order to qualify for QSBS treatment. The acquisition date determines the amount of gain that can be excluded, as follows:
- Between August 3, 1993 and February 17, 2009 – 50% exclusion
- Between February 18, 2009 and September 27, 2010 – 75% exclusion
- September 28, 2010 or later – 100% exclusion
- You purchased QSBS-eligible stock in 2008 for $100,000, and sold the stock in 2020 for $1,100,000. $500,000 of your long-term capital gain (50% of $1 million) is excluded from your taxable income.
- You purchased QSBS-eligible stock in June 2009 for $100,000, and sold the stock in 2020 for $1,100,000. $750,000 of your long-term capital gain (75% of $1 million) is excluded from your taxable income.
- You purchased QSBS-eligible stock in 2014 for $100,000, and sold the stock in 2020 for $1,100,000. The entire $1 million long-term capital gain is excluded from your taxable income.
- You purchased QSBS-eligible stock in 2018 for $100,000, and sold the stock in 2020 for $1,100,000. No QSBS exclusion is available, since you have held the stock for less than five years.
Cumulatively, taxpayers may exclude up to $10 million in gains on QSBS stock (per corporation) for federal income tax purposes. In other words, in Example #3 above, you may exclude up to $9 million of additional realized gains on the company’s stock in tax years after 2020. Investments in additional QSBS-eligible corporations create additional $10 million “buckets.”
State Tax Considerations
Generally, the QSBS exclusion also automatically applies to state income tax, because state income is usually based on federal adjusted gross income (AGI).
Massachusetts has special QSBS qualifications and provisions at the state level, as follows:
- Same active-business and $50 million asset requirements as federal
- Must be a C Corporation domiciled in Massachusetts and established on or after January 1, 2011
- Stock must have been purchased within five (5) years of the business’s date of incorporation
- Stock must be held for three (3) years, as opposed to the five-year federal holding period
- Capital gains from QSBS-eligible corporations (subject to above requirements) are taxed at 3%, rather than the regular “Part B” income tax rate (5% for tax years 2020 and later).
Planning Opportunities and Considerations
- Separate Taxpayers. As noted above, there is a $10 million cumulative limit per taxpayer. Spouses qualify as separate taxpayers for QSBS purposes (even if filing a joint return), as do other individuals or trusts paying their own taxes. Therefore, it might be worthwhile to gift some of your QSBS-eligible stock to your spouse or another family member, or contribute some of the stock to an irrevocable trust, to create additional $10 million “buckets.”
- Entity Types. Partnership entities (e.g., LLCs) may qualify for QSBS treatment if converted to a C corporation, as long as they meet the other requirements. S corporations converted to C corporations would not qualify for QSBS. Partnership interests qualify for the Qualified Business Income (QBI) deduction up to 20%, unless the partnership is converted to a C Corporation. If the QSBS exclusion outweighs the QBI benefit, the conversion could be worthwhile, but it is important to involve your tax advisor in this discussion.
- Capital Gains Rates. Because capital gains rates could be increasing under the Biden administration, it is worth considering holding QSBS-eligible stock, particularly if the value is likely to appreciate in the future. It’s important to involve both investment and tax advisors in these discussions.
- Rollover of Gain. Section 1045 of the Internal Revenue Code provides an additional savings opportunity for QSBS held less than five years. If the QSBS stock is held at least six (6) months, you may sell the stock and use the proceeds (rollover) to purchase stock in another QSBS-eligible company. This creates a “built-in gain,” where the original holding period is preserved. For instance, in Example #4 above, if you sold the stock in 2020 and within six months invested the proceeds into another company that qualifies for QSBS treatment, the capital gain is deferred and excluded from your 2020 income. The original 2018 purchase date then applies to the new investment for QSBS purposes.
As with all tax planning, it is imperative to work with a qualified advisor to evaluate how these complex matters impact your individual situation.