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What Is Qualified Small Business Stock? Thumbnail

What Is Qualified Small Business Stock?

By William Lalor, CFP®, CFA

Being an entrepreneur is hard. You face challenges that people who have never been an entrepreneur can’t even imagine. But it’s not all bad. In fact, every once in a while you get a big break and thank your lucky stars you decided to start your own business.

One of those big breaks for entrepreneurs comes out of Section 1202 of the Internal Revenue Code (IRC). If they meet certain requirements, your shareholders could get a huge tax break. That’s great news if you’re trying to entice investors with equity or you want to reward your key employees without impacting your cash flow.

What Is Qualified Small Business Stock?

Section 1202 of the IRC deals with qualified small business stock (QSBS). The law makes it possible for your shareholders to reap all of the gains of your growing company at lower tax rates or tax-free. Of course, this opportunity isn’t available for just anyone. The IRC provides a very specific definition of what a qualified small business is for the sake of this tax break.

These are the main conditions to qualify:

• Your company must be a U.S.-based C corporation. S corporations do not qualify.

• It must be an active business and not a holding company.

• Your business assets cannot exceed $50 million at any point after August 9, 1993. This applies both before and after you issue the stock.

• You cannot be in a business that offers personal services, such as operating a hotel, motel, or restaurant, banking, insurance, leasing, financing, investing, mining, or farming. Qualifying businesses include retailing, wholesaling, technology, and manufacturing.

• The stock has to be acquired in exchange for money or property, or as payment for services provided to your business. Stock transferred from one individual to another does not usually qualify for the tax break.

• Both your company and the shareholder have to agree to provide certain documentation in relation to the stock.

While those are the major requirements, it is not an exhaustive list. You must consult a knowledgeable tax advisor to determine if your specific corporation’s stock is eligible under Section 1202.

What Are The Tax Benefits Of Qualified Small Business Stock?

Instead of the usual capital gains taxes, some QSBS is subject to lower tax rates or even exempt from taxation. How your QSBS is taxed will depend on when it was acquired by the shareholder and how long it was held. The greatest benefits come from holding the stock for at least five years.

There are three different time periods for acquisition:

Stock Acquired Before February 18, 2009

No more than 50% of the gain can be excluded from taxation. In addition, 7% of the gain is subject to the alternative minimum tax (AMT).

Stock Acquired Between February 18, 2009, And September 27, 2010

As with shares acquired earlier, 7% of the gain is subject to the AMT. However, 75% of the gain can be excluded from taxable income.

Stock Acquired After September 27, 2010

When held for more than five years, this stock’s gain is completely tax-free. It is not subject to income tax, AMT, or even the 3.8% net investment income tax. If the stock is held between one and five years, then the gain is just a normal capital gain and taxed at those rates. The gain is a short-term capital gain taxed as ordinary income when the stock is held for less than one year.

There is a limit to the tax benefit your shareholders can receive, though. The excludable gain cannot be more than the greater of $10 million or 10 times the adjusted basis of the investment. If the stock is held between six months and five years, it can be sold and reinvested in another qualified small business within 60 days without triggering taxes due.

How Business Owners Can Leverage Qualified Small Business Stock

With the potential of completely tax-free gains, QSBS is a powerful tool. If you’re looking to raise capital, reach out to individuals and partnerships, since corporations do not receive any tax benefits from QSBS. Explain to your investors how the tax benefits work so that they understand the true value of your company’s stock.

Everyone wants to get in on the ground floor of a company like Google or Twitter, and your company may be the next big success. If you compensate your employees with stock, not only does it protect your precious cash flow, but they have the potential to reap all of their rewards tax-free. It will also motivate your employees to stay and work hard, as their financial gains are tied directly to the success of your company.

Payroll Issues

If you issue QSBS without restrictions, the value of the stock is taxable compensation to the employee. As such, you will have to pay payroll taxes and withhold income taxes as if you had paid the employee in cash instead of stock. Withholdings must be paid in cash, not equity. They can be calculated by adding the value of the stock to the regular salary and figuring the withholding as usual. Also, a flat 22% of the value of the stock can be withheld, going up to 37% when the value exceeds $1 million.


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