small business stock

Picture this:

  • You own stock in a company.
  • The price appreciates significantly.
  • You sell it.
  • You pay no tax on your profit.

Does it seem impossible during this volatile economic time when stocks are up one day, down another, and it seems like taxpayers owe money to the IRS on every trade?

It could happen with qualified small business stock (QSBS). It’s often referred to as Section 1202 stock because that’s the section of the United States tax code (also referred to as the Internal Revenue Code or IRC) that governs it. Issuing QSBS can be a smart thing for certain small businesses to do. When QSBS sales meet the rules set forth by IRS Section 1202, they may be eligible for exclusion from capital gains tax. This article explains when and how qualified small business stock could make sense for companies, QSBS eligibility criteria, how to qualify for the long-term capital gains exclusion, and what you can do to avoid federal income tax issues if you offer QSBS.

Be aware: This piece is for informational purposes only. Check with a small business financing expert before you make any final decisions about issuing QSBS.

Qualified small business stock: The basics

The federal tax break for QSBS is very attractive. However, QSBS rules are highly restrictive. Qualifying to issue QSBS requires the following:

  • The issuer must be a domestic C corporation (one based in the United States.) S corporations don’t qualify.
  • The corporation’s gross assets must be $50 million or less at all times before and after the issuance of the stock or as long as the company is in business.
  • The corporation must be an active business and not a holding company or pass-through entity for the entire time the stock is held.
  • The corporation must be in an industry sector other than:
  • Banking
  • Farming
  • Financing
  • Brokerage services
  • Financial services
  • Insurance
  • Investing
  • Leasing
  • Mining
  • Operating a hotel, motel, or restaurant
  • Personal services
  • In short, small businesses in manufacturing, retailing, technology, and wholesaling may qualify.
  • The corporation issuing the stock and the shareholder must consent to provide specific documentation related to the stock.
  • The stock can only be acquired in exchange for money or property or as payment for services provided to the corporation. Anyone who acquires qualified small business stock from someone else or through a secondary market typically cannot take advantage of the tax break related to the stock sale.
  • The investor must hold the stock for at least five years.
  • At least 80 percent of the issuing corporation’s assets must be used for operating its qualified trade or related subsidiary businesses.

Tax situation for QSBS shareholder

The tax treatment for shareholders depends on how long the stock is held and when it was acquired. All stock must be held for five years to enjoy the tax benefits, with one exception, which I will explain at the end of this section.

  • The tax exemption for stock acquired after September 27, 2010:
    • The gain is tax-free.
    • It’s free from income tax, alternative minimum tax (AMT), and net investment income tax.
  • The tax exemption for stock acquired between February 18, 2009, and September 27, 2010:
    • Seventy-five percent of the gain is excludable from gross income.
    • Seven percent of the gain is subject to the alternative minimum tax.
  • The tax exemption for stock acquired before February 18, 2009:
    • 50 percent of the gain is excludable from gross income
    • Seven percent of the gain is subject to the alternative minimum tax.

Be aware: In all cases, the excludable gain is limited to $10 million or ten times the adjusted basis of the investment, whichever is greater. Also, anyone who wants to sell QSBS before the minimum five-year holding period has an out that can allow them to enjoy tax benefits. The tax code allows them to defer the gain from the sale of QSBS if they roll over the proceeds from selling the qualified small business stock into another QSBS within 60 days.

QSBS benefits for small businesses

QSBS offers the possibility of earning big profits with limited tax liability. Organizations that are able to qualify as small businesses under QSBS guidelines should consider leveraging qualified small business stock for the following purposes:

  • Attracting investors. Startups and small businesses that want to grow can use QSBS as an attractive way to raise capital.

Be aware: The tax exclusion for QSBS only applies to individuals, not corporations. Individuals and individual partners in partnerships will be your only investor options. The stock can be acquired by a partnership so that a partner who is an individual and not a corporation can use the exclusion. The person can take advantage of it as long as they are a partner when the stock is purchased and the whole time they own it. The QSBS exclusion amount is limited to the partner’s ownership percentage in the partnership when the stock is acquired.

  • Rewarding employees. It’s allowable to exchange QSBS for services instead of paying traditional wages. It can be a good way for entrepreneurs at startups who have limited cash flow to pay top workers. It can also be a way to retain employees because of the five-year requirement of holding the stock to enjoy its tax benefits. Similar to stock options offered by larger corporations, QSBS also encourages employees who own the QSBS to work hard and help it succeed so the value of their stock increases.

Be aware: Issuing QSBS to employees does not come with restrictions. However, there are payroll tax costs to the company. The value of the qualified small business stock is the equivalent of the compensation that would have been paid for the work performed. This makes it taxable compensation to employees. It’s subject to income tax withholding, Social Security and Medicare (FICA) taxes, and FUTA (federal unemployment) tax. The withholding must be paid in cash. It’s usually withdrawn from other cash wages. It can be paid by the employee or by the company if it’s treated as additional income subject to its own payroll taxes)

Income tax withholding for the stock is treated as an in-kind payment. It can be handled in two ways:

  • Add the value of the stock to regular income and figure withholding on the total amount in your usual way.
  • Withhold a flat 25 percent of the QSBS If it exceeds $1 million, withhold 39.6 percent of the total.

Qualified small business stock: The bottom line

If you operate a C corporation — or are considering forming one — and work in an eligible industry, it’s worth considering whether issuing qualified small business stock is a wise move for you. QSBS can be an attractive way to raise capital or compensate top employees while enjoying the QSBS exemptions related to taxes. If you’re not sure, consult with a business finance expert. If you decide to move ahead with QSBS, work with a tax advisor to ensure that all conditions for being a qualified small business are met and that you structure your offering correctly.

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