Qualified Small Business Stock
Qualified small business stock can offer investors favorable tax saving opportunities. This article outlines some of the key considerations, requirements, and complexities surrounding QSBS. Taxpayers should consult with their tax advisors in evaluating whether they meet the criteria for Section 1202 gain exclusion before making any investment decisions based on this article.
- Internal Revenue Code Section 1202: A Brief Overview
- Qualified Small Business Stock (QSBS) Requirements
- Section 1202 Gain Exclusion Example
- Key Takeaways of Qualified Small Business Stock
Internal Revenue Code Section 1202: A Brief Overview
In order to incentivize early-stage investors to invest in small start-up businesses, Congress enacted Section 1202 of the Internal Revenue Code. As a result, taxpayers, other than corporations, became eligible to potentially exclude up to 100% of any gains from the sale of “qualified small business stock” (QSBS). Section 1202 may be of significant benefit to many investors; however, its requirements must be carefully evaluated in order to ensure taxpayers meet the criteria for gain exclusion eligibility.
Qualified Small Business Stock Requirements
QSBS refers to stock issued by a domestic C corporation that can potentially qualify for Section 1202 gain exclusion. Section 1202 of the Internal Revenue Code provides for a potential exclusion for qualified investors of up to $10,000,000 in capital gains or 10 times the stockholder’s adjusted cost basis, whichever is greater, upon the sale of QSBS, if all of the requirements of Section 1202 are satisfied. There is no election or filing requirements that need to be had at the time of issuance for stock in order to qualify as QSBS under Section 1202, however, the need to develop and maintain contemporaneous documentation outlining that each of Section 1202 requirements have been satisfied will be key in order to claim the gain exclusion under Section 1202.
In order to qualify as QSBS, the stock and its holder, among other things, must meet the following criteria:
- Must be issued by a domestic C corporation after August 10, 1993;
- The C corporation’s total aggregate assets may not exceed $50,000,000 before the time of issuance and immediately thereafter;
- Must be issued by a C corporation that uses at least 80% of its assets in an active trade or business (certain businesses are specifically excluded from Section 1202 eligibility);
- Must be held by a noncorporate taxpayers (individuals, partnerships, trusts and S corporations, are eligible for the gain exclusion under Section 1202);
- Must be acquired by the taxpayer on original issuance (in exchange for money or property other than stock, or as compensation for services); and
- Must be held for more than 5 years in order to qualify for gains exclusion.
Section 1202 Gain Exclusion Example
To illustrate the potential benefits of Section 1202 for the exclusion of any potential gains, consider the following example:
In 2015, Kirby received 1,000 shares of QSBS stock as compensation worth $2,000,000. In 2022, Kirby wishes to sell all of his shares of QSBS for $20,000,000. On the disposition of the QSBS stock, Kirby would owe federal income taxes on the $18,000,000 gain realized on the sale, which roughly equates out to $4,284,000 in taxes owed.
Assuming that Kirby satisfies all of the criteria for gain exclusion under Section 1202, then Kirby can exclude up to the greater of $10,000,000 in capital gains or ten times Kirby’s adjusted cost basis in the QSBS, $20,000,000. Here, Kirby will be eligible to exclude the entire $18,000,000 in capital gains from the sale of the QSBS stock from taxation because the amount of capital gains is less than ten times Kirby’s adjusted basis in the stock.
|< Adjusted Cost Basis >||< $2,000,000 >||< $2,000,000 >|
|Realized Capital Gain||$18,000,000||$18,000,000|