Startups are risky by nature, but they can also reap immense rewards – and the IRS offers tax incentives to encourage the entrepreneurial spirit behind these innovative enterprises. The qualified small business stock (QSBS) exclusion is a tax advantage that benefits eligible shareholders in qualified small businesses (QSBs).
Turn to trusted business law firm Allegis Law to explore qualified small business stock and other tax saving strategies that could save you millions.
The QSBS tax exclusion established by Internal Revenue Code Section 1202 provides shareholders a break on capital gains tax when they sell or exchange qualified stock. The tax break can go all the way up to 100 percent, which makes exploring your eligibility with a business and tax attorney well worth the investment.
Eligibility as a qualified small business in relation to QSBS tax exclusion comes with each of the following requirements:
If you intend to sell your business, consider reorganizing it as a corporation well in advance. By structuring your company for QSBS eligibility, you’ll be set up to maximize tax benefits when it comes time to sell. A common way to accomplish this is through an F-reorganization under IRC 368(a)(2)(F).
By planning for a QSBS sale transaction in advance, you can reduce or eliminate capital gains tax on the increase in value of your qualified small business stock under IRC Section 1202, or reinvest the proceeds into other qualifying investments to defer capital gains tax on the gain under IRC Section 1045. These two options are one of the most powerful tax exclusion and deferral strategies available, but require foresight and planning in the years leading up to the sale of your company.
A QSBS attestation letter is needed to claim a QSBS exemption. The attestation letter formally confirms that the company in question meets the requirements to be considered a qualified small business set forth by the IRS. The attestation letter demonstrates that the company was a QSB when the shares in question were obtained, which is necessary to receive the QSBS tax exclusion.
There are certain actions that disqualify a company for status as a QSB, which – in turn – can directly affect their shareholders’ eligibility for the QSBS tax exclusion.
When a company buys back shares that exceed a specific threshold, it can disqualify all the shares issued up to one year prior to the buyback, and a yearlong blackout period in which all shares issued after the buyback are disqualified may apply.
A company that qualified as a QSB prior to changing its business model to the provision of services that are outside eligibility for QSBS can lose its qualification.
When company assets are invested in non-cash deposit instruments that have liquidity terms of more than 24 months, such as money market funds or corporate bonds, it can affect the business’s eligibility for QSBS. The age of the company and the amount of the investment are deciding factors.
To qualify for QSBS, the business can’t exceed the $50 million asset threshold at the time the shares are issued or immediately thereafter, and growth beyond this limit generally translates to the loss of QSBS status. There is a workaround, however, that allows you to “stack” QSBS exemptions through business reorganization and trust planning.
A shareholder’s securities only become eligible for QSBS after the shareholder has exercised their stock option into actual shares. Once stock in the company is held, the shareholder must confirm the business’s QSB qualification. Only an individual, a trust, or another pass-through entity is eligible to hold QSBS stock.
From here, the stock must be held for at least five years before eligibility for the QSBS tax benefit applies. Selling shares prior to the completion of the holding period can lead to tax liabilities. Once the five-year holding period has elapsed, the stockholder can sell their qualified stock, and as long as all required conditions are met, the sale amount can be shielded from up to 100 percent of federal capital gains tax.
QSBS affords employees the ability to forego up to $10 million in federal capital gains tax, but investors stand to save considerably more. Investors can experience QSBS protections of up to 10 times their overall investment from long-term capital gains taxes or a total of $10 million in savings, whichever is greater. This means that investing $10 million can lead to savings of up to $100 million in federal capital gains tax.
Investors, in other words, should be very interested in whether or not the companies they invest in take full advantage of their QSBS eligibility. This plays out in the investor rights agreements (IRAs) that your firm creates for clients, and the specifics generally include terms like the following:
The selling of shares generally comes with either short-term or long-term capital gains tax rates, which can be exceptionally high. For example, short-term rates can top out at 37 percent while long-term rates can be as high as 20 percent – each of which can take a serious bite out of earnings. Achieving QSBS status allows investors to secure up to a 0 percent rate for federal capital gains tax, but the actual benefits are calculated according to when the shares were acquired.
The following cutoff dates apply:
Shareholders have the option of declaring their total eligible gains in one year or spreading the amount out over several years. Additionally, when a shareholder works for more than one company that qualifies for QSBS exemptions, they can claim the tax advantage afforded by each company independently.
An important point to make here is that the application and advantages of QSBS exceptions are legally complex and subject to legislative-driven change, which makes seeking the advice of a business and tax attorney critical.
Once the securities in question are exercised and converted to stocks within the window of eligibility for QSB, they retain their certification and tax benefit status – as long as the applicable tax code isn’t modified. This means that none of the following factors will alter the benefit status they enjoy:
When a merger or acquisition applies, one of the following options may be available to the stockholders:
Many state jurisdictions follow federal tax codes, including QSBS, but some do not. While Utah residents enjoy the same benefits at the state tax level, residents of the following states do not:
Both Massachusetts and Hawaii partially conform with the federal QSBS tax exclusion.
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