Qualified Small Business Stock and it's benefit to founders and investors
Qualified Small Business Stock, or QSBS, is stock issued from a qualified small business, which must be a domestic C corporation. 4 min read
2. General Overview
3. What are the potential pitfalls?
4. Who benefits from Section 1202?
What is Qualified Small Business Stock (QSBS)?
If you are a founder, angel investor, or an employee of a successful early-stage company, you need to be aware of certain qualifications that could help your investors protect up to $10 million from federal taxes. How so? The tax benefit is called the “Qualified Small Business Stock (QSBS) exclusion,” which is shorthand for a provision in Section 1202 of the Internal Revenue Code (IRC). This Section 1202 of the IRC outlines rules that potentially investors exclude from federal taxation the entire gain on the sale of Qualified Small Business Stock (QSBS). The gain exclusion is 50% for QSBS issued before February 18, 2009, and 75% for QSBS issued between February 18, 2009, and September 27, 2010. The Creating Small Business Jobs Act of 2010 increased the exclusion to 100% of the total gain for all QSBS issued after September 27, 2010.
Section 1202 allows a taxpayer to exclude up to 100% of the eligible gain realized from the sale or exchange of QSBS issued after September 27, 2010. The QSBS must be held for more than five years to qualify for the exclusion. QSBS must be issued by a “qualified small business” and generally be acquired by the taxpayer at original issuance, either in exchange for cash or other property (not including stock) or as compensation for services rendered to the corporation (other than services an underwriter of the stock).
Who is eligible for the QSBS exclusion?
Generally, you can use the exclusion if:
you have held the stock for at least five years;
the stock was issued after August 10, 1993;
the stock was issued by a domestic C corporation, with a max of $50 million of gross assets when the stock was issued;
the company uses at least 80% of its assets in an active trade or business (“Active Business Test”), and
you are a non-corporate taxpayer.
We often advise startup clients to think about qualifying for the QSBS exclusion by either incorporating as a qualifying C-Corp. or converting their limited liability company (LLC) to make investment from VCs more appealing. To qualify for the QSBS exclusion, investors will need a business that is properly structured, and they will need to plan for a multiyear investment
Two related and important Section 1202 requirements consist of the following:
“Activity Business Test” - Whether the test has been satisfied; and
“80% Test” - Whether at least 80% of the corporation’s assets are used in the active conduct of one or more “qualified trades or businesses”.
Active Business Test
QSBS is only available if the corporation satisfies the “active business requirement” during substantially all of the stockholder’s holding period. The test will be satisfied if:
The issuer was a C corporation both when the QSBS was issued and when the QSBS was sold
During substantially all of the taxpayer’s QSBS holding period:
The corporation was a C corporation
At least 80% (by value) of the corporation’s assets were used in the active conduct of a trade or business
No more than 10% by value (in excess of liabilities) of the corporation’s assets consisted of stock or securities in corporations which are not subsidiaries
For purposes of this rule, assets actually should be used in start-up activities or research and development. No more than 10% (by value) of the corporation’s assets should consist of real estate or investments not used in the active conduct of a trade or business.
The “80% Test”
At least 80% (by value) of a corporation’s assets must be used in the active conduct of one or more qualified business activities (the “80% Test”).
This requirement is satisfied unless more than 20% of the corporation’s assets (by value) consists of the sum of
assets used in business activities that are not qualified trade or business activities, and
other assets held or used by the corporation for any purpose other than in the active conduct of a qualified trade or business. Included in this excluded category are investment securities, non-active business-related real estate and excess cash (subject to the exceptions described below for certain start-up activities).
What are the potential pitfalls?
First, the five-year requirement is critical. Second, Satisfying the 80% Test on a continuing basis during a taxpayer’s QSBS holding period is one of the most difficult Section 1202 requirements. The determination of whether a corporation has met the 80% Test during a stockholder’s entire QSBS holding period requires both a constant look at the current nature of the corporation’s business activities and a determination of whether the corporation ever experienced a disqualifying accumulation of non-active business-related assets. Third, there are legal and financial caveats to consider when electing to become a C-Corporation. To take advantage of the benefit the investor will have to sell the stock. Buyers generally want to buy assets because with stock, they inherit any liabilities and prior issues. Finally, if you don’t meet the 5-year requirement, you may still be able to save the benefit.
Who benefits from Section 1202?
If you’re already a C-Corporation, you should take advantage of this provision in relation to conveying to investors that you have met the requirements from the company’s end. Investors will need to make sure that the appropriate steps have been followed when it’s time to sell the stock.
If you are a startup founder looking to set up a new company today that will have outside investors, Section 1202 should be one of the important parts in dealing with and deciding how to best structure of your entity. Founders and legal advisors should review the business model, the investors, goals, exit strategy, timeline, etc. to make a choice on the best entity structure.
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