Key Takeaways
Entrepreneurs and the investors who support them hold special places in the economy. Equipped with ingenuity, tenacity, and a vision for the future, entrepreneurs often forego productive employment relationships in pursuit of creating value out of nothing but big ideas and hard work. Meanwhile, the venture capitalists and private equity investors who empower these enterprisers allocate capital away from more tried and tested investments for a big risk and the chance to get in on the ground floor of the next big thing.
Often efforts fail, and these risk-takers walk away with only frustration, bitter lessons learned from failure, and a redoubled desire to succeed next time. But sometimes these endeavors succeed in big ways, and the entrepreneurs, investors, and the larger economy all prosper from this success.
Congress has seen fit to create incentives for these business pioneers and the risks they take with special treatment in the Internal Revenue Code (“IRC”). Chief among these incentives is IRC § 1202, the benefit for Qualified Small Business Stock (“QSBS”).
In simple terms, this benefit allows a taxpayer who holds QSBS to eventually sell that stock and realize 100% of its gains tax free.
If used correctly, this provision is, dollar-for-dollar, the largest tax benefit in the IRC and a powerful endorsement for investing in fledgling businesses. But, as with any tax benefit, the benefit for entrepreneurs and investors has strict rules that must be closely followed.
For an investment to be considered Qualified Small Business Stock, and thus eligible for the benefits of IRC § 1202, it must meet the following requirements:
Only eligible taxpayers can hold QSBS. Eligible taxpayers include individuals and pass-through entities, such as partnerships, S Corps, regulated investment companies, and common trust funds. C Corporations are ineligible and can never hold QSBS.
For stock to be QSBS, it must be stock of a domestic C Corporation. International companies cannot qualify for this tax benefit. Similarly, a domestic company must have incorporated and existed continuously as a C Corp for its stock to be considered QSBS.
Stock must be acquired directly from the corporation to the taxpayer by an original issuance in exchange for money, other property, or services rendered to the corporation. This does not have to be the initial issuance of stock when the business incorporates, but it does have to be an issuance directly from the corporation to the shareholder.
This rule does allow for some exceptions, specifically stock received by the taxpayer as a gift, an inheritance, or a distribution from a partnership. However, stock acquired from a secondary market will not be QSBS.
At all times before the stock issuance and immediately after, the issuing company’s aggregate gross assets must not exceed $50 million. The term “aggregate gross assets” is a special term for IRC § 1202, and it does not mean the fair market value or the book value of the company. Instead, the aggregate gross assets are the business’s cash and adjusted basis of all other property held by the business. This is not necessarily the measure of a business that is commonly tracked by accountants.
At least 80% of the company’s assets must be used in at least one “qualified trade or business.” This means that stock in a holding company will not be QSBS. Additionally, certain businesses are excluded from being considered “qualified trades or businesses”, including:
Unfortunately, the IRS has not provided any real guidance as to the boundaries and limits of these categories.
Taxpayers must hold the stock for at least five years before sale. Stock received by gift, inheritance, or distribution from a partnership shall have its holding period from the prior holder tack to the new holder. Also, there is some relief for taxpayers who simply cannot hold the stock for at least five years. IRC § 1045 essentially allows a taxpayer to roll over a QSBS investment into new QSBS investment if the original investment needs to be liquidated prior to reaching the five-year mark.
The tax benefit of IRC Sec. 1202 is only available upon the “sale or exchange” of QSBS. That is, the QSBS’s stock gains must be realized to be excluded from taxable income. The taxpayer holding QSBS does not have tax benefits in the stock unless and until he or she sells the stock.
If a taxpayer holds stock that meets all these rules, then the stock will be considered QSBS. Upon sale the of the QSBS, the taxpayer will not be taxed on any gain realized in such sale. While this is a significant benefit, there are caps. The limit on tax-free gain will be the greater of $10 million or 10x the original investments.
Even with these caps, the tax benefit of IRC § 1202 is substantial. Consider that an entrepreneur can invest up to $50 million in their business, operate an active business for five years, and at the end of this business sell shares for up to $550 million and pay no tax on the sale ($50 million tax-free return of basis and $500 million as 10x basis tax-free under IRC § 1202). This massive tax-free return is, in fact, the largest tax benefit available in the IRC.
As a final point, QSBS is inherently fragile. Any violation of the above rules, however minor, will eliminate the IRC § 1202 benefits from the otherwise QSBS. Indeed, it is easy—perhaps common—for a taxpayer holding stock to move or arrange the stock in such a way as to remove its QSBS status. If the QSBS status is lost, it is gone for good. Additionally, some businesses trying to attract investors by offering potentially QSBS may be offering stock that is not qualified for the benefits of IRC § 1202.
The best option for both shareholders hoping to hold QSBS and companies working to issue QSBS is to seek guidance from professional tax advisors with expertise in IRC § 1202.
LBMC has professionals who can guide you and your business through all aspects of IRC § 1202 and all other tax situations you may face. Reach out to a tax professional at LBMC today.
David Frederick, J.D., LL.M. is a Senior Manager of Taxation in the Private Client Group of LBMC, PC. David is an attorney by background and his practice at LBMC is focused on advising high-net-worth individuals on matters of estate planning, business succession planning, and tax mitigation. He can be reached at david.frederick@lbmc.com or 615-690-1931.
LBMC tax tips are provided as an informational and educational service for clients and friends of the firm. The communication is high-level and should not be considered as legal or tax advice to take any specific action. Individuals should consult with their personal tax or legal advisors before making any tax or legal-related decisions. In addition, the information and data presented are based on sources believed to be reliable, but we do not guarantee their accuracy or completeness. The information is current as of the date indicated and is subject to change without notice.
