The Qualified Small Business Exemption (QSBS exemption) can shield up to $10 million, and sometimes more, of stock appreciation from capital gains tax. The rules are complex but worth understanding; there are substantial tax savings to be had by...

The Qualified Small Business Exemption (QSBS exemption) can shield up to $10 million, and sometimes more, of stock appreciation from capital gains tax. The rules are complex but worth understanding; there are substantial tax savings to be had by claiming this rare exemption. 

C-Corp executives considering a primary stock offering can use them to incentivize investors to purchase a primary stock offering. 

If you’re an investor, the QSBS exemption could help you tap into new benefits from existing qualified equities, or you can seek out QSBS extensions as part of an overall tax-efficient investment strategy.

This article will help you determine if your investments or corporation are potentially eligible for the exemption. However, the IRS rules surrounding this tax break are complicated and go beyond what we’ve covered in this article. If you want to dive deeper into this topic, you can connect with one of the experts on our business tax services team.

What is the QSBS Exemption?

The QSBS exemption was created by Congress in 1993 to encourage long-term investment in small businesses. Housed under section 1202 of the tax code, it provides for a 50-100% exemption from capital gains tax for qualified stock investments. 

QSBS Rules for Qualification

The QSBS exemption has a long list of qualifying factors, and even if you are operating in an eligible industry, there may be rules that cause you to be excluded. 

Non-Qualifying Industries

Before looking at the lengthy list of qualifying rules, first, check that the corporation isn’t on the list of expressly prohibited businesses. 

The IRS defines a qualified trade or business as any field other than the following: 

Health Law Engineering Architecture Accounting Actuarial science Performing arts Consulting Athletics Financial services Brokerage services Farming Hotels Motels Restaurants

Finally, businesses reliant on the reputation of an owner or employee, don’t qualify. An example would be Mint Mobile, a company that is arguably reliant on the reputation of Ryan Reynolds as their spokesperson. 

Qualifying Industries

The law doesn’t outline specific industries that qualify. However, after considering those that are explicitly excluded, there are quite a few that remain: 

Manufacturing Technology Research and development Software Retail Transportation Educational services Telecommunications 

If you’re unsure if your business is eligible, it’s worth checking with an indinero business tax services expert. 

Detailed Eligibility Rules

Once you’ve verified that IRS rules do not explicitly exclude the industry, the next step is to verify that all other eligibility requirements are met. Here’s a breakdown of those rules: 

Stock must be from a primary offering after 1993; no secondary market purchases qualify. The minimum holding period is five years unless one uses the QSBS rollover (detailed below). A C Corporation must issue the shares. Such C-Corp must be valued at no more than $50M before and directly after the issuance (determined by accounting for the issuance proceeds). This includes the aggregate value of all parent and subsidiary corporations. The corporation may not own securities of other corporations (other than its subsidiaries) over 10% of the value of its assets. At no point beginning three years before the issuance may the corporation buy back stock exceeding 5% of the value of all outstanding stock. The beneficiary of the exemption must be an individual or passthrough entity. The stock must be purchased with cash, property (not stock), or as payment for services; advisory shares and employee stock options are valid. Beneficiaries and related persons may not participate in a stock buyback from the corporation anytime six years before the issuance and through the entire holding period.

QSBS Rollover

The QSBS rollover allows investors to sell before the 5-year exclusionary period is over and remain eligible for the exemption. 

As long as they held the original stock for six months and invested all proceeds into another qualified stock within 60 days of selling the original batch, eligibility is maintained and the holding period carries over.

QSBS Rules by State

While the QSBS applies universally to federal capital gains taxes, some states still levy capital gains taxes. Here is the list of states that do not conform to the federal rules: 

California Mississippi  Alabama Massachusetts  New Jersey Pennsylvania  Wisconsin

QSBS Tax Treatment

The QSBS exemption shields the greater of $10M of gains, or 10x the cost basis of purchased stock, from capital gains tax. 

How much capital gains tax an investor is safe from depends on when the stock was purchased. Sometimes it’s 50%, others 75% or even 100%. 

Keep in mind that the alternative minimum tax (AMT) and net investment income tax (NIIT), rules designed to ensure high-income earners don’t pay an unfairly low tax rate, may still apply. Additionally, due to rules surrounding the AMT, the capital gains tax rate on non-excluded capital appreciation is 28%

Stock Issuance	QSBS Exclusion	AMT Applies?	NIIT Applies?
8/11/1993 – 2/18/2009	50%	yes	yes
2/19/2009 – 9/27/2010	75%	yes	yes
9/28/2010 – present	100%	no	no

For example, if an investor sold qualified stock purchased during the 50% exclusionary period that had accumulated $1,000,000 of capital gains, they would owe capital gains tax on only $500,000. 

This would come to a capital gains tax bill of $140,000 ($500,000 * 0.28). 

How to Report QSBS on Your Tax Return

There are two primary steps for reporting the sale of a QSBS on your tax return. Anyone who sells a capital asset must:

Fill out form 8949, where the dates and details of transactions are recorded. Transfer the net results from form 8949 to your schedule D filing. 

While the IRS doesn’t require any special documentation to be submitted with your filing, claiming the QSBS exemption is rare. It may put you at heightened risk of an audit.

To protect yourself, be sure to keep your financials in order and, if you run a business, have a system for tracking business expenses that explicitly maintains separation between personal and entrepreneurial finances. 

Conclusion

The QSBS is a tax-efficient investment strategy that can facilitate wealth preservation for some and accelerate wealth creation for others. The benefits are substantial and investors should carefully examine eligibility requirements. 

If you think your investment portfolio may contain qualifying stocks, reach out to an indinero accounting services expert today. 

---

View Entire Post