Selling Your Business Tax-Free With Qualified Small Business Stock

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Under the right circumstances, a taxpayer may exclude up to 100% of the gain on the sale of the stock of a business. This alert discusses the major requirements, benefits, and pitfalls encountered when planning and utilizing Internal Revenue Code section 1202, Qualified Small Business Stock (QSBS). The full rules contain many exceptions, limitations, and modifications that are beyond the scope of this short article. This is intended for general information and does not address all these nuances.

 

QSBS has been in the law for many years but has received increased attention since the enactment of the Tax Cuts and Jobs Act (TCJA). QSBS only applies to C corporations (C corps), and TCJA's lowering of the corporate tax rate to 21% encouraged more taxpayers to consider operating as a C corp. While not the only factor to consider when selecting choice of entity, QSBS must be part of the analysis.

 

QSBS must be held at least five years while the business remains an active trade or business to qualify for the exemption. The start date is usually straightforward but may be complicated by options, convertible debt, or stock issued as compensation under section 83. To qualify as a small business, assets cannot exceed $50 million immediately after the issuance of the QSBS, including the cash or property contributed in exchange for the stock. Assets may subsequently exceed this threshold.

 

C corp status is generally attractive to startup companies wishing to attract outside investors. If so, the stock will qualify as QSBS if all other criteria are met. Alternatively, a startup may choose to operate as a partnership in its early years to pass expected losses through to its owners. But if it wishes to qualify its stock as QSBS, it must convert to a C corp before its value exceeds $50 million. This includes the fair market value of the partnership interests contributed, including any goodwill.

 

100% of gain on stock acquired after September 27, 2010 is excluded. Older shares qualify at a lower benefit. A taxpayer may not exclude more than $10 million dollars of gain, or (if higher) ten times the basis of the QSBS sold during the year. Gains exceeding those limits qualify for long-term capital gain tax treatment. Unlike other tax breaks with built-in expiration dates, section 1202 is permanent.

 

QSBS can only be issued by a C corp, so partnership and S corp investments do not qualify. The business must remain a C corp until the stock is sold. A partnership converting to corporate status can issue QSBS in connection with its incorporation, but the 5-year holding period begins on the date of incorporation regardless of how long the business operated as a partnership. Existing stock from an S corp which revokes its S election does not qualify, but new stock issued after it becomes a C corp is eligible.

 

QSBS cannot be owned by a shareholder which is itself a C corporation. All other entities - individuals, partnerships, LLCs, S corps, and trusts - can take advantage of the exclusion. Shareholders that are passthrough entities, including partnerships and S corps, give the benefit to their owners.

 

Section 1202 requires that QSBS be original issuance stock received directly from the corporation in exchange for cash or property (other than stock), or for services provided by the shareholder. Care must be taken to document that founders of startups contribute at least a small amount of assets or receive their stock in connection with the performance of services under section 83.

 

As noted, the general rules stated in this alert do not address the myriad details associated with almost every aspect of this area. We urge you to contact your LMC professional if you wish further guidance. All our prior Alerts are available on the Updates page of our website.

 

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