Learn about one of the best breaks around...qualified small business stock (QSBS).
Qualified Small Business Stock: An Often Overlooked Tax Windfall
February 26, 2015
It’s no secret that small businesses have long been the growth engine of the US economy. With that in mind, over the years Congress has packed the tax code with lots of breaks for those investing in small business. One of the best breaks around — and no secret to experienced angel and venture capital investors in Silicon Valley — is qualified small business stock (QSBS).
What Is QSBS?
Like all things in tax, the IRS definition of qualified small business can get complicated, and it changes depending on the section of the tax code in question. For our purposes, we’ll be focusing on Section 1202 of the Internal Revenue Code (IRC).
To qualify as QSBS under Section 1202:
- The stock must be in a domestic C corporation (not an S corporation or LLC, etc.), and it must be a C corporation during substantially all the time you hold the stock.
- The corporation may not have more than $50 million in assets as of the date the stock was issued and immediately after.
- Your stock must be acquired at its original issue (not from a secondary market).
- During substantially all the time you hold the stock, at least 80% of the value of the corporation’s assets must be used in the active conduct of one or more qualified businesses.
To elaborate on the last point, active conduct means a qualified business can’t be an investment vehicle or inactive business. It can’t be, for example:
- A service business in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services
- A banking, insurance, financing, leasing, investing, or similar business
- A farming business
- A business involving the production of products for which percentage depletion can be claimed
- A business of operating a hotel, motel, restaurant, or similar business
As I mentioned before, this can get really complicated, since each of the points above could be expanded into an in-depth discussion. That being said, in my experience working in Silicon Valley, many early-stage investments in C corporation technology companies meet these requirements.
Tax Benefits of QSBS
If you’ve held stock qualifying as QSBS for at least five years when it’s sold, a portion of your gain—or in some cases all of your gain—can be excluded from federal tax. The remaining capital gain is then taxed at a 28% rate (assuming you are in the 15% or 20% bracket for regular long-term capital gains). The maximum gain eligible for exclusion on any one investment is the greater of $10 million or 10 times the taxpayer’s adjusted basis in the stock (which is normally not greater).
It bears mentioning that this post focuses on the federal tax treatment for QSBS. Some states follow the federal tax treatment, while others may have their own set of rules. California, for example, offered preferential treatment for QSBS in prior years, but eliminated the benefit for tax years after 2012. The bottom line: Don’t assume your state provides a benefit for QSBS gain.
In recent years Congress wanted to incentivize more investment in small businesses, so it progressively increased the amount of gain exclusion. Per the table below, there are now several possible treatments for gain exclusion depending on when you purchased your private company stock. Note as well that the gain excluded from capital gains tax is not subject to the 3.8% net investment income tax (NIIT).
The table below summarizes the QSBS rules for regular tax (versus alternative minimum tax) depending on the time frame when the QSBS was first acquired:
(Click to enlarge)
The 100% exclusion window was set to expire at the end of 2013, but late last year Congress extended it through the end of 2014. As of January 1, 2015 the exclusion reverted to 50%, though some think Congress may extend the 100% window yet again. Also noteworthy is the fact that President Obama’s current budget proposal includes making the 100% exclusion rule permanent.
To demonstrate the actual tax savings of selling QSBS versus regular stock, let’s look at an example. Say we have a married taxpayer with $450,000 in joint ordinary taxable income. We’ll use $450,000 so we can demonstrate the benefits of QSBS for a taxpayer who is in the 20% long-term gain bracket and also subject to the 3.8% NIIT. Furthermore, let’s assume the taxpayer realizes a long-term capital gain of $100,000 by selling stock on October 1, 2015.
The following scenarios illustrate how the tax due varies depending on the type of stock and its purchase date:
(Click to enlarge)
The tax rate is only 23.8% (20% plus the 3.8% NIIT) for the lot purchased in 2013 because none of the stock qualifies as QSBS. As explained above, the higher 31.8% rate (28% plus the 3.8% NIIT) must be applied to QSBS stock.
At this point you may be thinking that QSBS sounds too good to be true, and if you’re subject to the alternative minimum tax (AMT), you would be right. The analysis above oversimplifies the QSBS tax calculation by assuming the taxpayer is not in AMT for the year of sale. For most taxpayers, however, AMT is likely to apply. While Section 1202 excludes a portion of the gain from regular tax, it also adds back 7% of the excluded gain as an AMT preference item. This is true for all purchase periods except the 100% exclusion window, as shown below:
(Click to enlarge)
*If the acquisition occurred before January 1, 2000, AMT add back is 42%.
To see the impact of the AMT add back, let’s take a look at our examples again, now assuming the taxpayer is already in AMT before realizing the $100,000 long-term capital gain. Let’s also assume the flat 28% AMT rate fully applies. (Note that lower income levels may also benefit from a partial AMT exemption. I have intentionally used the higher income in this example to clearly show the AMT impact without any exemption.)
Compare the following scenarios for the stock sold below:
(Click to enlarge)
As you can see, AMT reduces the potential benefit of selling QSBS for all periods except during the 100% exclusion window. That being said, there’s still a substantial benefit to be had.
Qualifying for QSBS Treatment
Unfortunately federal and state tax authorities sometimes make it difficult to claim your QSBS benefit. I recommend taking the following steps to support that your sale of QSBS will qualify:
1. Document your purchase.
Keep good records for each purchase of stock in your private portfolio, including:
- The date purchased
- The amount paid
- A copy of the canceled check or wire with your account statement showing the funds leaving your account
- A copy of the share certificate
2. Have your stock certified.
If you think you’re making an investment that may eventually qualify for QSBS treatment, ask the company to certify to the following:
- That it is a domestic C corporation
- That it has $50 million or less in assets immediately after your purchase
- That at least 80% of the company assets are used in the active conduct of a qualifying business
Note that if you wait several years to ask for this information, the company may not be able to provide it, either due to staff turnover or unclear records.
3. Watch the clock.
Keep track of the date when your investment reaches the five year holding period. You wouldn’t want to sell right before it has hit the threshold if instead you could have waited and paid significantly less, or perhaps zero, federal tax.
4. Seek a professional.
If you’re making a lot of QSBS investments, work with an accountant who understands the rules well.
Other QSBS Opportunities
QSBS treatment can provide significant tax savings to your private investment portfolio. While this post looked at the benefits available under Section 1202, there are other sections which may provide benefits as well, including Section 1045 for the rollover of gain from one QSBS to another. If you’re going to invest in small businesses — including technology start-ups — it’s well worth your time to engage a qualified tax accountant to help you learn how to use QSBS to your portfolio’s advantage.