One of the most substantial tax breaks for noncorporate taxpayers today is the federal income tax exclusion available upon the sale of qualified small business stock (QSBS).
Under Section 1202, capital gains from qualified small businesses are exempt from federal taxes, if the following conditions are met:
The investor must be an individual, not a corporation
The investor must have acquired the stock at its original issue and not on the secondary market
The stock must be purchased with cash, property, or as payment for a service.
The stock must be held for at least five years
At least 80% of the issuing corporation’s assets must be used in the operations of one or more of its qualified trades or businesses
Sec. 1202 provides that if a noncorporate taxpayer sells QSBS issued after Sept. 27, 2010, the first $10 million of gain (or 10 times basis in the stock, if greater), is 100% excluded from federal income taxation. Thus, a sale of $10 million of QSBS represents $2.38 million in federal tax savings, compared with a $10 million gain realization on the sale of non-QSBS.
With an increase in taxpayers claiming QSBS gain exclusion will come increased IRS attention and, hopefully, increased guidance on the IRS’s positions regarding some of the areas in which the law is still unclear or unsettled.
QSBS Overview
Sec. 1202 was enacted to incentivize investment in certain small businesses by permitting gain exclusion upon the sale of qualified small business stock (QSBS).
The requirements of Sec. 1202 are straightforward but nuanced in practice. To qualify for the benefit, the following minimum requirements must be met:
The company must be a domestic C corporation
The company, during substantially all of the seller's holding period for the stock, must meet the active business requirement
The company must have had gross assets of $50 million or less at all times before and immediately after the equity was issued
The stock must have been received at original issuance
The stock must have been held for more than five years prior to the sale
Requirements for QSBS Tax Benefits
The tax treatment for a QSB stock depends on the acquisition date and the holding period. Section 1202 of the IRC, enacted in 1993, allows noncorporate shareholders to exclude a portion of the gain from selling qualified small business (QSB) stock held for five years.
100% capital gains exclusion: The exclusion of QSBS acquired after Sept. 27, 2010, includes exemptions from AMT and NII tax.
75% capital gains exclusion: For QSBS acquired from Feb. 18, 2009, to Sept. 27, 2010. However, 7% of the excluded gain is subject to AMT.
50% capital gains exclusion: For QSBS acquired from Aug. 11, 1993, to Feb. 17, 2009.1 However, 7% of the excluded gain is subject to AMT.
The California Franchise Tax Board does not conform to federal rules for qualified small business stock, and does not have a capital gains tax rate. As such, California residents will pay ordinary income tax on the proceeds.
Start-up founders and early employees with restricted stock may benefit from filing an 83(b) Election. An 83(b) election allows startup founders and early employees to elect to be taxed on the fair market value of their restricted stock awards at the time of grant rather than at the time of vesting. This election can be particularly beneficial for those who anticipate a significant increase in the value of their stock over time, reducing their tax liabilities over the long term. An 83(b) election can help shareholders satisfy the five-year holding period requirement more quickly. By electing to be taxed at the time of the grant, the shareholder’s holding period starts from the grant date, rather than the vesting date.
Examples of QSBS Tax Benefits
Consider a taxpayer who files as a single individual with $410,000 in ordinary taxable income. This income places them in the highest tax bracket for capital gains tax (20%).5 If they sell qualified small business stock acquired on Sept. 30, 2015, and realize a profit of $50,000, they may exclude 100% of their capital gains, resulting in $0 federal tax due on the gains.
Now, assume the taxpayer purchased the stock on Feb. 10, 2009, and sold it for a $50,000 profit after five years. The federal tax due on capital gains would be calculated as 20% of 50% of $50,000, equating to $5,000.
Stockholders who want to sell qualified small business stock (QSBS) not held for the minimum five-year period can still benefit. Section 1045 of the IRC allows them to defer the gain by reinvesting the proceeds from the sale of QSBS into another QSBS within 60 days.
What Are the Biggest Tax Benefits of QSBS?
The biggest tax benefit of qualified small business stock (QSBS) is the potential to exclude up to 100% of capital gains from federal taxes, which can significantly reduce the tax burden on investors. Exclusions from the alternative minimum tax (AMT) and net investment income (NII) tax for QSBS held for over five years further increase these tax advantages.
What Is the 5-Year Rule for QSBS?
The five-year rule requires that investors hold their QSBS for at least five years to qualify for the full capital gains tax exclusion. This means that if the stock is held for a minimum five-year period, investors can potentially exclude up to 100% of the gains from federal taxes, depending on when the stock was acquired.
The Bottom Line
Qualified small business stock (QSBS) offers significant tax advantages, making it an attractive option for those investing in small, innovative companies. Key benefits include the potential to exclude up to 100% of capital gains from federal taxes if the stock is held for at least five years, depending on when it was acquired.
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