Taking A Dive into Qualified Small Business Stock

November 14, 2019

An overarching goal of business owners is minimizing the amount of taxes they have to pay; after all, it’s their hard-earned money!  The government will inevitably get a cut, but if the business is a qualified small business, they can greatly reduce how much their growth is taxed.

 

A qualified small business is an active C corporation with fewer than $50 million in gross assets on and immediately after stock issuance.[1]  There are other specifications the business must also meet to qualify, and if the business meets the criteria, the stock issued is considered qualified small business stock (QSBS).  Rather than jumping right into the Internal Revenue Code (IRC) that makes this qualification of stock so valuable, let’s look at an example first.

 

Imagine you own a small tech company that meets the criteria of being a qualified small business, and you issue stock to yourself and some of your employees as part of your pay structure.  After a few years, your business has exploded, and you take it public.  After watching your stock price steadily rise, you decide to sell some of the qualified stock that you’ve held for five years.  Now, if this were regular stock, you’d get hit with potentially 23.8% long-term capital gain tax.[2] However, you have QSBS, so your capital gains tax liability is exactly 0%. Although this sounds fantastic, not all small businesses qualify for QSBS.  Let’s dive into the parameters that businesses must meet to qualify.

 

As stated above, the company must have less than $50 million in gross assets when the stock is issued, and it must be an active C corporation.  An active C corp. means at least 80% of the corporation’s assets must be used in the active conduct of qualified industries or trades.  This is where it gets tricky because the following list is not considered to be qualified industries:[3]

  • Health

  • Law

  • Engineering

  • Architecture

  • Hospitality

  • Farming

  • Insurance

  • Finance

  • Mineral extraction industries

In addition to these limitations, the date at which the stock was issued can change the tax benefits as well.  Any QSBS issued after September 27, 2010, and held for more than five years can exclude 100% of gains from taxes.  Before this date, the exclusion decreases in a tiered fashion, the lowest of which is 50%.[4]  Even so, this could result in incredible tax savings.

 

Another rule to consider with QSBS relates to how much you can exclude in a single year.  The excludable gain on the sale of qualified stock for a single tax year is limited to the greater of a) $10M less the total amount of eligible gain on the issuer’s stock that the taxpayer excluded in prior years, or b) 10 times the taxpayer’s adjusted basis of qualified stock sold during the tax year.  Simply put, if you have a significant amount of QSBS, you might not be able to take all of the tax savings in a single year.[4]

 

Although qualified small business stock can be an incredibly useful tax savings tool, there are a lot of guidelines that must be met.   The current tax law has become more favorable to C corporations than in the past, which has certainly added to the attractiveness of QSBS, but it still may not make sense to change your business from a pass-through entity to a C corporation.  However, it is always a good thing to consider all angles when business and tax planning.  We encourage our entrepreneur clients to consider such tools but implore them to think of QSBS holistically and not from a singular lens.  Lastly, we are not CPAs and highly recommend speaking to one before making any tax-planning decisions.  LBW is happy to help explore such an idea in conjunction with your CPA to provide more information on the intricacies of qualified small business stock!

Sincerely,

LBW

 

 

 

[1] U.S. Master Tax Guide (2019), 1905, Exclusion of Gain from Small Business Stock

 

[2] Internal Revenue Code – includes top 20% capital gain and 3.8% Net Investment Income Tax, depending on your federal income tax bracket

 

[3] Assuming all appropriate qualified small business criteria are met

 

[4] U.S. Master Tax Guide (2019), 1905, Exclusion of Gain from Small Business Stock

 

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