Qualified Small Business Stock (QSBS) Explained

There are 3 tax codes every American entrepreneur and investor should be familiar with:

• Section 1202

• Section 1045

• Section 1244

In this blog, we’re going to cover all three and tell you how they can save you hundreds of thousands, even millions, of dollars in tax breaks for your start up.

If you’re reading this, congratulations! Starting a new business is exciting.

Now, let’s talk about selling it…Ha!

We’re not kidding.

One of the most important things you can do as an entrepreneur is plan for a successful exit while you are growing your business.

Every plan, every decision, every milestone should be backed by the idea that you will one day pass on the business – either to an employee or an interested investor.

Why should you worry about exiting already?

There are a few reasons why this is the case.

It’s important to make sure that all stakeholders are aware and aligned with the steps to achieve a successful exit.

It’s also a good idea to know ahead of time who might be interested in taking over or buying out the business.

But most importantly, it’s important to make sure that you have a strategy in place to minimize tax liability.

Selling your business will trigger capital gain taxes, so it’s important to know ahead of time what your options are, and structure your business in a way that will be most profitable for you.

You need to understand and plan for the most tax advantageous exit scenario now, which is what we want to discuss here today.

What are your options for getting around capital gain taxes?

Selling your business can trigger capital gain taxes, so what are your options?

If you sell your business at a gain, and your business investment qualifies as qualified small business stock (QSBS), Section 1202 allows you to exclude from federal taxable income the greater of $10M or 10 times your stock basis.

For example, let’s say you started a technology company, and got bought out.

You may be able to exclude a percentage of the capital gain from your federal taxable income if your investment is classified as QSBS.

So, tell me more about Qualified Small Business Stock (QSBS)

QSBS is treated favorably for capital gains purposes if both the investor and the company meet certain requirements.

How much of a tax break you receive will depend on when you purchased the stock and how long you hold it.

That’s another reason why it’s important to work with an experienced start up accountant from the start of your business in order to structure your business effectively.

In order to qualify for QSBS, these are the requirements that both must meet:

The taxpayer must be an individual, trust, estate or passthrough entity, but cannot be a corporation
QBSB must be acquired in an original issuance
The issuer must engage in a qualified trade or business. Qualified trade or businesses exclude professional services, legal, accounting, financial, banking, engineering, medical and dental services. Examples of qualified business activity include retail, wholesale, manufacturing, and technology.
Stock issuer must be a domestic C corporation. So, a passthrough entity doesn’t qualify
You must hold the stocks for more than 5 years
The issuer gross assets immediately after QSBS issuance must not exceed $50M

Sounds great. But what if I held my QSBS stocks for less than 5 years?

There are ways around this requirement.

For instance, if you hold your QSBS for more than 6 months before you sell, Section 1045 allows you to defer the capital gains if you rollover the proceeds into another QSBS within 60 days.

Here are the requirements for that:

You must own the original stocks for more than 6 months before its sale
You must reinvest the entire sales proceeds (not just the capital gain) into another QSBS
The replacement QSBS must meet the qualifications of qualified small business stock (QSBS) for at least 6 months immediately after the taxpayer acquisition

What if my start up fails and I lost my investment?

We’re glad you asked.

While nobody starts their business with the intention of failing, it happens more often than not.

So, it’s equally important to understand how to recuperate your costs – if any – when it happens.

The good news is that Section 1244 allows ordinary loss treatment if your investment qualify as QSBS.

If your investment qualifies as QSBS, you can deduct up to $50K ($100K if you file Married Filing Jointly) losses against your ordinary income.

Section 1244 can be complicated, so here are a few things you need to know:

There is no election to make or special filing with the IRS to designate Section 1244 stock
The determination of Section 1244 stock must be made at the time of issuance. Section 1244 stocks can be common or preferred stock
Section 1244 stock must be held by an individual or a partnership
The money or property received for Section 1244 stock must not exceed $1 million in aggregate. Once the $1 million is surpassed, the corporation can’t issue additional 1244 stock in subsequent years.

Our final advice?

As an entrepreneur, you must be familiar with applicable tax benefits when seeking deals or structuring your investments.

If your business qualifies as QSBS (qualified small business stock), you may be eligible for big tax breaks.

And finally, always work with an experienced start up accountant from the beginning to structure your business in a way that minimizes your tax burden. It will save you a lot of money, and headaches, down the road.

Until next time!

< Older Post Newer Post >

Book 15-Min Call