Section 1202 Qualifying Small Business Stock (QSBS): Major Tax Benefits to Small Businesses

There aren’t many provisions within the US tax code that allow for permanent exclusion of gains realized from the sale of an asset.  However, Section 1202 provides this opportunity to small business owners and investors.  If you’re a business owner looking to start a new business, considering a sale of your company or considering changing the structure of your business, Section 1202 could provide significant tax benefits to you.

Many small to medium sized businesses have chosen the limited liability company (LLC) entity structure due to its flexibility and legal protection.  However, with the introduction of QSBS and the reduction of the C corporation tax rate to 21% as part of the Tax Cuts and Jobs Act, the C corporation has become a more attractive entity choice for some companies.

QSBS Qualifications:

Section 1202 stock can be held directly by an individual, trust, estate or through a flow-through entity like a partnership.  In order to qualify, the following conditions must be met:

  • The stock must be acquired via a direct investment in a C corporation (a conversion of an LLC taxed as a partnership to a C corporation could also qualify)
  • The stock must be held for five years from the date of investment
  • The corporation’s assets must be less than $50 million at the time of investment and at all times prior to investment
  • The C corporation’s assets must be used at least 80% in a qualified trade or business, which generally includes all businesses except for:
    • Financial services
    • Professional services
    • Farming
    • Real estate & other passive activities
    • Oil, gas & mining

QSBS Tax Benefits:

The potential tax savings for QSBS is equal to the greater of $10M or 10 times the taxpayer’s adjusted basis in the QSBS being sold.  The percentage gain that a taxpayer can exclude depends on when the QSBS stock was issued, as follows:

  • No gain exclusion – stock issued before August 11, 1993
  • 50% gain exclusion – stock issued between August 11, 1993 and February 17, 2009
  • 75% gain exclusion – stock issued between February 18, 2009 and September 27, 2010
  • 100% gain exclusion – stock issued after September 28, 2010

Updates as part of the proposed Small Business Jobs Act

The Small Business Jobs Act is making its way through Congress, and if passed, would provide enhancements to QSBS, as follows:

  • 50% gain exclusion would be available if QSBS was held for three years, instead of five
  • 75% gain exclusion would be available if QSBS was held for four years, instead of five
  • 100% gain exclusion for QSBS held for five years or more
  • QSBS treatment would also be available for S Corporations, in addition to C Corporations

Summary:

QSBS rules are complex and potentially changing, but QSBS status can be very valuable upon a qualified stock sale.

 

For more information or assistance, please contact RDG+ Partners at 585-673-2600.