Qualified Small Business Stock – What Is It and Why Does It Matter to Startup Investors

Investors in startups frequently require the corporation to warrant in connection with the sale of its stock that the startup’s shares are qualified small business stock (QSBS) within the meaning of Section 1202 of the Internal Revenue Code (the Code). Section 1202 allows certain taxpayers to exclude from taxation up to 100% of gain realized on the sale of QSBS. Section 1045 of the Code further allows certain taxpayers to defer recognition of potentially all such gain if the taxpayer reinvests in it another small business’ QSBS within 60 days.

Any type of stockholder other than a C corporation can qualify for claiming Section 1202’s gain exclusion, including individuals, trusts, and pass-through entities such as partnerships (e.g., LPs and LLCs) and S corporations. The amount of gain excludable from tax depends on when the stock was acquired. But, generally, one can exclude up to 100% of the qualified gain for QSBS-eligible stock first acquired on or after September 27, 2010. The gain excluded in this manner is limited, on a “per issuer” basis, to the greater of $10 million or ten times the taxpayer’s basis in the stock.

QSBS means any stock of a domestic C corporation that is (i) a “qualified small business” upon issuance of the stock; (ii) acquired by the taxpayer directly from the corporation for money, other property (not including stock) or as compensation for services, and (iii) sold by the taxpayer while the issuer remains a C corporation. To prevent abuse, stock acquired by the taxpayer will not be considered QSBS if (i) the corporation buys any such stock from the shareholder or a related person within two years before or after issuance of the shares for which the exclusion is sought; or (ii) the corporation recovers more than 5% of the aggregate value of its stock within one year before or after issuance (with exceptions for certain events). Let’s break down these two disqualifying conditions:

(i) Buyback Condition:

• If the corporation whose stock is being considered for QSBS treatment repurchases its stock from the shareholder seeking the exclusion or from a person related to that shareholder within a two-year window surrounding the issuance of the stock in question, the stock will not qualify. This window includes both two years before and two years after the stock’s issuance. This rule aims to prevent shareholders from claiming QSBS benefits on stock that the company is effectively taking off the market shortly before or after it’s issued, which could be indicative of manipulative tax planning.

(ii) Stock Redemption Condition:

• If the corporation redeems, or buys back, more than 5% of the total value of its outstanding stock within a one-year period surrounding the stock issuance (either one year before or one year after), the stock in question will not qualify as QSBS. This rule is in place to prevent companies from significantly altering their capital structure to manipulate eligibility for QSBS tax benefits. However, there are exceptions to this condition for buybacks that occur due to death, divorce, disability, incompetency, and certain minor (de minimis) transactions, acknowledging that such events are typically not conducted with the intention of tax avoidance.

A “qualified small business” is a domestic C corporation which meets these qualification requirements:

1. The company must be an active business (as opposed to a holding company).
2. The company must have had gross assets of $50 million or less at all times before and immediately after the equity was issued.
3. At least 80% of a company’s assets must be actively used in a qualified trade or business. Excluded business types are determined by the IRS and include companies that:

• • Perform services related to health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, finance, banking, insurance, leasing, investing, or brokerage;
  • Rely on an employee or owner’s reputation (i.e. if it endorses products or services, uses an individual’s image, or has an employee make appearances at events or on media outlets);
  • Produce products, such as fossil fuels, for which percentage depletion (a type of tax deduction) can be claimed;
  • Operate a hotel, motel, restaurant, or similar business; or,
  • Are a farming business.

Gain from the disposition of qualified small business stock by a partnership or S corporation, that is allocated to the capital account of a partner or shareholder is eligible for §1202 exclusion if the requirements of a qualified small business and qualified small business stock are met and if the taxpayer held its interest in the entity on the date the stock was acquired until the stock’s disposition. To avoid the bypass of the five year holding period requirements, the amount of gain so excluded cannot exceed the amount determined by reference to the taxpayer’s pro-rata interest in the entity upon the acquisition of the stock.

Section 1045 allows a taxpayer, other than a corporation, selling “qualified small business stock,” to defer gain on such sale by rolling over the gain into a new investment in qualified small business stock. Rollover treatment under §1045 is possible if: (i) the taxpayer has held the original stock for more than six months; (ii) the taxpayer reinvests the proceeds from the sale into new qualified small business stock within a 60-day period after the sale; and (iii) the taxpayer makes a special election to claim §1045 treatment on his/her federal income tax return for the year of sale.

The amount of gain that can be deferred is limited to the cost of the new QSBS purchased within the 60-day period after the sale of the original stock, minus any portion of that cost that has already been used to defer gain under Section 1045.

The application of these rules in any instance is complex and requires planning. Contact your tax advisor to discuss how these rules apply to your situation.

Disclaimer: This summary is made available by DPA Law PC (the “firm”) for informational purposes only. It is not meant to convey the firm’s legal position on behalf of any client, nor is it intended to convey specific legal advice. Accordingly, do not act upon this information without seeking counsel from a licensed attorney engaged to provide advice based on your specific circumstances. This article also is not intended to create, and receipt of it does not constitute, an attorney-client relationship. This article is published “as is” and is not guaranteed to be complete, accurate, or up to date.