Take Advantage of Tax Incentives to Enhance Your ROI.
The exemption for Qualified Small Business Stock (QSBS) is an often overlooked, but potentially big tax break for both founders and those investing in small businesses.
Small businesses have been the growth engine of the US economy since the last recession. Congress has helped fuel that engine with provisions in the IRS tax code that can reward people who start and invest in certain types of small businesses.
One of the best breaks available is the qualified small business stock (QSBS) exemption – something savvy angel and venture capital investors in Silicon Valley and beyond are familiar with.
The primary benefit of a QSBS exemption is that you can save taxes when you sell the shares of a QSB, providing that both the investor and the company have met all the requirements for the entire time the shares have been held.
But exactly what sorts of small businesses qualify as a QSBS?
Determining this requires some careful navigation of the IRS section 1202 code, best done with the help of a capable CPA:
- The stock must be that of a Domestic C Corporation (not an S Corporation nor LLC) whose aggregate gross assets do not exceed $50 million.
- The shares of the C corporation that were acquired must have been issued after 8/10/93 when the law was first passed.
- The shares must be held for more than five years.
- The shares must be acquired at its original issue, not from a secondary market (redemptions are limited).
- 80% (by value) of the corporate assets must be used in the active conduct of the qualified business.
What types of business qualify? This is best answered by listing what is not eligible. A qualified business can’t be an investment vehicle or inactive business. The following types of businesses do not qualify:
- Performance of services in fields such as health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics or financial services or brokerage services.
- A farming business.
- A business involved in the production of products for which percentage depletion can be claimed.
- A business operating a hotel, motel or restaurant.
All this being said, many early-stage investments in technology companies do in fact meet the requirements for a QSBS.
How much tax can you save?
A lot depends upon when you purchase and when you sell the shares, and whether the alternative minimum tax will apply. The benefits have fluctuated over the years as the tax laws have changed. However, for shares acquired since September 28, 2010 the benefits are the most substantial.
If you can meet all the requirements, then you can exempt from the capital gains tax of 20%, plus 3.8% net investment income tax – up to a limit of the greater of $ 10 million or 10 times your adjusted basis in the stock, whichever is greater.
In recent years Congress wanted to incentivize more investments in qualified small businesses, so it progressively increased the amount of allowable gain exclusion. The 100% exclusion is effective as of September 28, 2010 and is now permanent. The alternative minimum tax does not apply for the gain that is eligible for the 100% exclusion.
An important safety tip here: Anyone who wants to take advantage of the QSBS tax relief needs accurate documentation that they in fact are entitled to these exemptions. Owners and founders potentially stand to gain the most from QSBS – because they may have a large gain and they were likely early investors.
Another QSBS benefit is the DEFERRAL feature that is available. If you lack the 5-year holding period, and are reinvesting in another QSBS you can roll over the gain into the next qualified investment.
In order to qualify for the rollover deferral into the next investment:
- The QSBS must be held for more than six months.
- The taxpayer must purchase the replacement QSBS within 60 days from the date of the sale.
- The election must be made in the tax return.
In the event you experience QSBS losses (Per IRS section 1244):
- Losses of up to $50-$100K may be deducted as an ordinary loss rather than a capital loss.
- The benefit applies to the first $1 million of capital raised by the company.
- The company must derive more that 50% of its gross receipts from sources other than passive investment income.
- This does not apply to shares received for services rendered.
- Document your QSBS purchase: Date, amount paid, record of payment and copy of the share certificate.
- Keep track of time: Know the date when you’ve held the shares for five years and one day before your sell.
- If you feel that your shares qualify, get in touch with your QSB and request documentation which proves that your shares in the Corporation have met “all the QSB requirements at all times.” Since this exemption will be part of your individual tax return, it is important for you to be able to substantiate this exemption and have the information available should your tax return be audited.
Because this process and documentation can be quite complicated, your QSB may need to engage a qualified CPA who is familiar with these provisions to prepare the necessary documentation that the investors can use as evidence to support the Qualified Small Business Exemption in their personal tax returns.
This material has been prepared for general informational and educational purposes only and is not intended, and should not be relied upon, as accounting, tax or other professional advice. Please refer to your advisors for specific advice.