Tax Planning with Qualified Small Business Stock (QSBS)

What is QSBS?

QSBS is a special tax designation created in 1993 to encourage investment in small businesses. In 2010 Congress passed the Creating Small Business Jobs Act and replaced the original 50% exclusion with a 100% exclusion for QSBS issued after September 27, 2010.

QSBS Qualifications

To qualify for QSBS tax benefits, certain requirements must be met. These include:

• Legal Structure: QSBS can only be issued by a domestic (US) C-Corporation.

• Gross Assets Test: A corporation can only issue QSBS when it has less than $50 million of Gross Assets at the time of stock issuance and immediately afterward.

• Issue Dates: The stock was issued after August 10, 1993 (50% exclusion), between August 18, 2009 and September 27, 2010 (75% exclusion) or after September 27, 2010 (100% exclusion). For eligible stock issued before September 27, 2010, the non-excluded gains are taxed at a 28% federal income tax rate.

• Qualified Shareholders: Individuals, trusts, partnerships, single-member LLCs, S-Corporations, and regulated investment companies can hold QSBS. C-Corporations cannot hold QSBS.

• Minimum Holding Period: QSBS must be held 5+ years to qualify under IRC Section 1202 for the capital gain exclusion. However, shareholders may rollover gain from one QSBS-eligible company to another QSBS-eligible company under IRC Section 1045.²

• Qualified Trade or Business: At least 80% of the corporation’s assets must be used in qualified trade or business activities for “substantially all” of the shareholder's holding period. This excludes companies where the principal asset is the reputation or skill of 1 or more of their employees (e.g. consulting and professional services companies), and banks, financial services, insurance companies, farms, hotels, and restaurants.

• Original Issuance: QSBS is received directly from the company in exchange for money or other property or as compensation for services provided to the corporation. QSBS status and the established holding period may be preserved for transfers by gift, death, or as a distribution from a partnership. Stock purchased from founders or other early shareholders in secondary transactions is disqualified.

• Corporate Redemptions: QSBS status can be lost if the corporation redeems more than a de minimis amount of its stock and the purchased stock has an aggregate value of more than 5% of all outstanding shares. The redemption rule is applied using a 2-year window, beginning 1 year before the issuance of the stock. Redemptions from the taxpayer or a related person lower the de minimis threshold to 2% of all outstanding shares with a 4-year window, beginning 2 years before the issuance of the stock.

• At Risk Capital: QSBS status will be lost if an offsetting short position is established before the 5-year holding period is met. After the 5th anniversary, hedged QSBS will also be disqualified unless an election is made to recognize gains on the date the short position was established.

² Internal Revenue Code Section 1045

Planning Opportunities

There are many planning techniques that can potentially enhance the benefits of QSBS. From the strategic early exercise of stock options to leveraging rollover provisions under IRC Section 1045, here is a list of planning opportunities for investors and founders to optimize their QSBS holdings.

• Marital Doubling: Gifting QSBS to a spouse is a potential strategy for claiming a $20 million exclusion on a jointly filed tax return.

• Non-Grantor Trusts for Multiple Exclusions: Gifting QSBS to trusts for children or other family members can provide an additional $10 million exclusion for each beneficiary. The trusts need to be non-grantor and separate taxpayers with unique tax IDs. Grantor trusts (including IDGTs and GRATs) are disregarded for income tax purposes and do not provide an additional exclusion.

• Sell Stock in a Zero Tax State: QSBS is a federal tax benefit, and most states provide similar exclusion benefits for state-level income taxes. However, 6 states do not conform to Federal QSBS: CA, PA, NJ, MS, AL, and HI. Residents of these states can move to a tax-friendly state before selling shares or gift shares to a non-grantor trust in one of the favorable states.

• Convert an LLC to a C-Corp for 10x Basis: This strategy involves building up substantial value in an LLC (taxed as a partnership) before converting to a C-Corp. The fair market value of contributed property is used to determine the taxpayer's basis in the new C-Corp. After five years, the taxpayer can sell stock and exclude capital gains equal to 10 times (10x) their basis in the C-Corp. With proper planning, it is possible to far exceed the $10 million exclusion using this strategy.

• Multi-Year Liquidation: It is possible to claim both the $10 million exclusion and the 10x basis exclusion if stock sales span two tax years and the $10 million exclusion is exhausted first. Stock sold in future years can apply the 10x basis rule on any remaining cost basis.

• IRC 1045 Rollover: If the 5-year holding period is not met, sale proceeds from QSBS held for at least 6 months can be reinvested in another QSB company within 60 days and the taxpayer can make an election to defer gains.

• IRC 368 Merger or IRC 351 Exchange: QSBS benefits can be preserved with a properly structured merger or acquisition. In a tax-free corporate merger or exchange, a taxpayer can defer capital gains on start-up stock exchanged for shares of a larger acquiring corporation. The replacement shares acquired by the start-up founder retain the QSBS exclusion benefits and the holding period from the exchanged shares. However, future appreciation in replacement shares stock will be taxable when sold.

• Carried Interest: Venture capital partners can receive QSBS treatment on their carried interest. The partner must have held their partnership interest at the time the QSBS was acquired by the fund.

• Partnership Distributions: Investors can receive QSBS treatment on the sale of stock inside of a partnership or on shares originally purchased by the partnership and distributed in-kind to the partners.

• 83(b) Election: An early exercise of non-qualified stock options with a timely filed 83(b) election starts the 5-year holding period for QSBS. For incentive stock options (ISOs), an 83(b) election helps reduce exposure to alternative minimum tax. However, the holding period for QSBS appears to begin when ISOs vest. An 83(b) election can also be filed for restricted stock within 30 days of grant. Without an 83(b) election, the holding period for QSBS begins when restricted stock vests.

• IRC 1244 Loss: Early investors in a failed start-up may be able to deduct their QSBS capital loss against ordinary income (e.g. W2 wages, dividends, interest). IRC Section 1244 treatment is only available for stock issued before the start-up held $1 million of aggregate capital. The maximum annual deduction is $50,000 per person or $100,000 for a jointly filed return.

• Documenting QSBS Status: Companies may provide documentation to support a QSBS position, including the gross assets at the time of issuance. Some companies provide a detailed memo, whereas others are less helpful and direct employees to their personal tax preparer for guidance.

• Tax Opinion Letters: A tax attorney can be engaged to research and help substantiate a QSBS claim with a tax opinion letter. These letters may provide some protection if the IRS takes an adverse position to a QSBS claim on a tax return. If the opinion letter provides substantial authority or reasonable basis (with disclosure on the tax return) for the QSBS exclusion, penalties may be mitigated. However, interest would still be due on any underreported income.

Frequently Asked Questions