If you are the holder of Qualified Small Business Stock (QSBS), Section 1202 of the U.S. Internal Revenue Code (IRC) gives you a way to dramatically limit your tax burden when you sell that stock. In fact, you may be able to exclude up to 100% of the capital gain. For sellers, the tax savings regarding QSBS can be extensive and it can be a key factor in an M&A transaction. However, to qualify for the exclusion, certain criteria need to be met.

What is QSBS?

According to the IRC, QSBS is stock issued by a C corporation after August 10, 1993, the date the Omnibus Budget Reconciliation Act of 1993 (OBRA '93) was enacted. In addition, the issuing corporation must be a Qualified Small Business (QSB). This means it must be a U.S. corporation and at all times before the stock was issued and immediately after, the aggregate gross assets of the corporation do not exceed $50 million. Furthermore, at least 80% of the issuing corporation's assets must be used for a qualified trade or business. For the purposes of QSBS, manufacturing, retailing, technology, and wholesaling are some examples of qualified trades or businesses, but banking, insurance, finance, leasing, investing, hotels, and farming are not.

To be eligible for the capital gain exclusion, you must hold the QSBS for at least five years and you must be a non-corporate taxpayer, such as an individual, trust, or eligible partnership.

How much gain can you exclude?

The amount of gain that you can exclude depends on when the QSBS was issued. You can exclude:

  • 100% if the QSBS was issued after Sept. 27, 2010
  • 75% of the gain if the QSBS was issued between Feb. 18, 2009 and  Sept. 27, 2010
  • 50% of the gain if the QSBS was issued between Aug. 11, 1993 and Feb. 17, 2009

Stock issued before Aug. 11, 1993 does not qualify for gain exclusion.

Sec. 1202, however, does add a limitation: the amount of capital gain eligible for exclusion is limited to the greater of $10 million or 10 times the basis of the QSBS sold in a given year.

Here are two examples:

Example 1: William holds qualified small business stock shares in ABC Corporation which he purchased for $10,000. Five years later he sold the stock for $10 million. William can exclude all $10 million of the gain on the sale of his QSBS (the $10 million exclusion limit).

Example 2: Jane holds qualified small business stock shares in XYZ Corporation which she purchased for $1.5 million. Five years later she sold the stock for $20 million. She can exclude $15 million of the gain on the sale of her QSBS (10 times the basis of the QSBS).

Planning for QSBS

If you own a company, the QSBS gain exclusion can be an important part of your exit strategy. Like other things related to the exit of your company, early planning for QSBS is important. Corum Senior Vice President Steve Jones puts it this way: "When you get to the point of selling your company, it might be too late to take advantage of the QSBS exclusion. So plan early and invest the time to understand these requirements and ensure you are compliant."

A significant element of that effort is validating your eligibility for the QSBS exclusion. Here are some things you will need to prove:

  • The issuer of the stock is a domestic C corporation.
  • The issuer of the stock is a Qualified Small Business.
  • 80% or more of the corporation's assets are used for a qualified trade or business.
  • You are a non-corporate taxpayer, such as an individual, trust, or eligible partnership.
  • You held the stock for at least five years.

The validation will require you to provide documentation such as:

  • Articles of Incorporation to prove that the issuer is a C corporation.
  • Financial records to prove that the issuing corporation had less than $50 million in aggregate assets throughout the pertinent period, and that 80% or more of the corporation's assets are used for a qualified trade or business.
  • The stock purchase agreement to prove that you held the stock for at least five years.
  • Tax returns that prove you are a non-corporate taxpayer.

QSBS can be an important part of your investment strategy. Jones notes that whether you are an entrepreneur planning for an exit or simply targeting a personal windfall, incorporating QSBS into those plans is key. For instance, to take advantage of the QSBS gain exclusion, you may want to consider a change in your company's structure if it is not a C corporation and you are the holder of stock in the company.  Perhaps your company is structured as an S corporation or a Limited Liability Company (LLC). There are important assessments involved in that decision. The tax advantages in the near term of an S corporation or LLC may outweigh the tax benefits of the QSBS gain exclusion. Also, during substantially all of the holding period of the stock, the issuing corporation must remain a C corporation. So if you make a structural change of your company to a C corporation, it needs to be done early enough in the stock holding period to qualify for the exclusion. In addition, when you sell your company, it’s generally more favorable for preserving QSBS benefits to do it as a stock sale, rather than an asset sale. So consider that when you are planning for an M&A transaction.

Other considerations

There are other things to consider regarding QSBS. For instance, the $50 million aggregated asset limit may impede some investments in your company. Suppose your company has aggregated assets of $40 million. If you seek a capital investment of more than $10 million, it would likely disqualify any stock your company issues from being considered QSBS.

There are also QSBS-related considerations regarding stock transfers.  And there are issues related to whether certain services or activities performed by a company are considered qualified trades or businesses by the IRS.

It's important to work with tax and financial advisors to understand the intricacies of Section 1202 of the IRC and plan accordingly to ensure that you qualify for the QSBS gain exclusion. Again, plan early. Jones says, “It pays to begin with the end in mind.”