What is the Qualified Small Business Stock (QSBS) Exclusion?
The QSBS exclusion is one of the many tax advantages afforded to small business owners and investors who take risks and create businesses that drive our economy.
While business owners enjoy many more tax advantages than W-2 employees, none have the ability to wipe away millions in tax liability like the QSBS exclusion.
To illustrate the QSBS benefits, criteria, and planning strategies, we're going to follow the story of how Joe used the QSBS exclusion to save millions in taxes and set his family up for generations.
Who is Joe?
Joe is a successful tech founder/executive with a wife and three kids.
Joe started Companion Protectors (CP), a technology company with a product that helps pet owners track their pet’s health vitals and increase preventative care.
When he started CP, he read about business owners saving millions in taxes through something called the Qualified Small Business Stock (QSBS) exclusion.
Joe was too busy with his family and business to read through the specifics. So, he asked his team of tax, legal, and financial advisors to look into it for him.
Proactive Qualified Small Business Stock (QSBS) Planning
Joe’s advisors dug into Section 1202 of the tax code and presented him with a summary of potential tax savings and the criteria he would need to satisfy.
QSBS Exclusion Amount
The gain you can exclude depends on when you acquire the stock.
• After 9/27/2010 - 100% gain exclusion
• 2/18/2009 – 9/27/2010 - 75% gain exclusion
• 8/11/1993 – 2/17/2009 - 50% gain exclusion
Assuming you meet the requirements outlined later, you can exclude 100% of the gain. However, your exclusion is limited to the greater of:
• 10 times your stock’s basis.
QSBS Exclusion Examples
Joe received 500,000 shares of CP stock at $0.05/share ($25,000 basis).
7 years later, Joe sells CP for $11M ($22/share). Joe excludes $10M of his $10,975,000 gain.
Instead, assume Joe made a substantial upfront investment and received 500,000 shares of CP stock at $3/share ($1,500,000 basis).
7 years later, Joe sells CP for $16M ($32/share). Joe will exclude the entire $14.5M gain because 10 times his $1.5M basis gives him a $15M exclusion.
Joe’s QSBS Tax Savings
Most states follow federal rules for QSBS exclusion, but some don’t, and there are nuances from state to state. So, we’ll only look at federal tax savings.
Gains of this size would be taxed at 20% for capital gains and 3.8% for Net Investment Income Tax (NIIT).
Excluding $10M of gain saves $2,380,000 ($10M*23.8%)
Excluding $14.5M of gain saves $3,451,000 ($14.5M*23.8%)
Multiplying QSBS Exclusions
Even with a $10M+ exclusion, highly appreciated, low-basis QSBS can still leave you with millions in taxes.
However, the QSBS exclusion is applied on a per-taxpayer basis. This opens the door to creating multiple exclusions through gifts to individuals or entities like irrevocable trusts.
Recipients are treated as if they acquired the stock in the same manner as the transferor, and they inherit the transferor’s holding period.
How Multiple QSBS Exclusions Work
Joe has 1,000,000 shares, with a $50,000 basis ($0.05/share). Companion Protectors is currently valued at $25M ($25/share).
He transfers 163,333 shares ($4,083,325) to three irrevocable trusts, one for each child. This uses $12,249,975 of his lifetime estate exemption. However, all future appreciation in the trusts will be exempt from the 40% estate tax.
Years later, Joe sells CP for $40M ($40/share). The table below illustrates the difference in capital gains tax savings between the gifting strategy and if Joe kept 100% ownership.
Deferring Leftover QSBS Gain
Even after using multiple exclusions, Joe still has a $2.5M tax liability. He can either pay the tax today or he can use another QSBS strategy known as a Section 1045 Rollover.
To be eligible for a 1045 Rollover, you must hold the original QSBS for over 6 months and reinvest the proceeds into one or multiple new Qualified Small Businesses (QSBs) within 60 days of the sale.
If the replacement company maintains QSB status and the stock appreciates, Joe may qualify for another exclusion on the reinvested gain if he holds the replacement QSBS for more than 5 years.
Alternatively, Joe can continue to defer the gain on the original QSBS and spread the gain over several tax years by selling a portion of the replacement QSBS each year.
A 1045 Rollover can also help QSBS owners who can’t meet the 5-year holding period on the original QSBS.
Qualified Small Business Stock (QSBS) Eligibility & Criteria
Joe was thrilled to hear about the potential QSBS benefits and planning ideas.
However, his advisors stressed the importance of proactive planning and meticulous documentation from business formation through sale to ensure Joe and Companion Protectors satisfied the strict criteria required for a tax-free exit.
Basic QSBS Criteria
• Must be a US C-Corporation when the stock is issued AND sold
• Stockholders must hold the stock for more than 5 years from acquisition
• C-Corps holding stock in other C-Corps are not eligible for a QSBS exclusion
• Stock must be acquired directly from the C-Corp in exchange for money, property, or services (unless transferred by gift, at death, or other qualified transfer)
The following QSBS criteria are more nuanced.
QSBS Eligible Trades or Businesses
Businesses and trades like:
• Performing arts
• Financial services
• Any other businesses where the primary asset is the skill or reputation of one or more employees
Are NOT considered qualified businesses.
However, manufacturing and technology companies like CP typically qualify.
The QSBS 80% Test
CP must use at least 80% of its assets to conduct activities related to its qualified trade or business during “substantially all” of the QSBS holding period.
For example, if CP’s assets total $10M, CP’s working capital and other relevant assets must be at least $8M.
The QSBS 10% Real Property Limitation
The value of real property not used to actively conduct qualified business activities cannot exceed 10% of CP’s assets.
Office space where CP’s employees work would be considered real property used to actively conduct business.
Office space CP owns and leases to another business would not be.
The QSBS 10% Stock Limitation
If CP purchases a minority interest(s) (<50%) in other corporations, the value of those interests cannot exceed 10% of CP’s assets.
If CP owned:
• 5% of ABC corp
• 20% of XYZ corp
The value of those interests cannot be more than 10% of CP’s net assets.
The QSBS $50M Test
For CP’s stock to qualify as QSBS, “aggregate gross assets” cannot exceed $50M before and immediately after stock issuance when accounting for cash or other property received in exchange for the stock.
Aggregate gross assets = cash + adjusted tax basis of company assets
Think of this as cash received during funding rounds + value of other company assets
QSBS Share Redemptions
QSBS may be disqualified if there are significant share buybacks by the company during specified time periods.
Other Qualified Small Business Stock (QSBS) Considerations
QSBS for Employee Stock & Options
Employees who receive equity through stock options or other equity arrangements are also eligible for the QSBS exclusion! However, the 5-year holding period doesn’t start when you receive an option. It starts when you exercise and convert the option to shares (exercise date).
This warrants planning around the early exercise of options and the potential tax due on the difference between the option strike price and share value.
QSBS for Venture Capital Investing
Individuals or partners in venture capital funds who invest in QSBs will also be eligible for the QSBS exclusion. This can be a potential selling point for founders looking to raise outside funding.
The QSBS gain exclusion can save small business owners and investors millions of dollars on a successful exit.
This post provides a foundation for understanding QSBS, but there are hundreds of other nuances and strategies that require diligent planning and execution by a team of professionals to maximize the value you stand to gain.
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