QSBS or Qualified Small Business Stock-Not Just Another Acronym

By: Randall A. Denha, J.D., LL.M.

The 2018 Tax Cuts and Jobs Act (“Tax Act”) caused many sweeping changes to the tax laws and introduced new tax laws, modifying others and leaving some untouched. One of the tax laws which remain untouched and the subject of this article, is the favorable treatment of Qualified Small Business Stock (“QSBS”) under the tax code. While there are a multitude of different types of business entities a taxpayer may form for a business (i.e. LLC, partnership, S-Corporation, etc.), only a C-Corporation will benefit from the QSBS rules. If a taxpayer selling stock in a C-Corporation qualifies as QSBS stock then the taxpayer may not have to pay any federal income tax (or state income tax depending on the state) upon the sale of such stock.

In order to qualify for the tax free nature of the QSBS, there are certain rules and the timing of a taxpayer’s ownership will govern how much is exempt from tax. Any gains from selling QSBS stock that you acquire on or after 9/28/10 are potentially eligible for a 100% federal income tax exclusion (as will be discussed below). The Tax Act permanently installed a flat 21% corporate federal income tax rate for 2018 and beyond so, the worse-case scenario is a 21% flat tax. So if you own shares in a profitable QSBS and you eventually sell those shares when you’re eligible for the 100% gain exclusion, that flat 21% corporate rate will be all the tax that’s ever owed to Uncle Sam. In addition to when you acquired the stock, there is a five year holding period. A taxpayer must own the stock for over five years to cash in on this almost unbelievably good deal, and not all shares will qualify. More specifically, the QSBS rules permit a taxpayer who has held QSBS for more than five years to continue to exclude 100% of the gain on up to $10 million provided the shares were issued on or after September 28, 2010. Similarly, taxpayers who have not met the five year holding period can roll QSBS gain into new a qualified small business as long as they reinvest within 60 days.

In light of the new Tax Act, the QSBS rules are back in vogue and should be reviewed by any business owner selling C-Corporation stock. The following are the are the requirements for QSBS treatment. Even if all are not met, read on, as there may be an alternative or workaround.

Only a Certain Amount of Gain Can Be Excluded (But It Could Be a Big Number)

To break the suspense, we begin with the rules regarding the maximum gain that can be tax-free if the following QSBS requirements are met:

• The 100% gain exclusion — which translates to a 0% tax rate — is only available for sales of QSBS shares acquired on or after 9/28/10.
• For QSBS shares acquired between 2/18/09 and 9/27/10, you can potentially exclude up to 75% of the otherwise-taxable gain.
• For QSBS shares acquired after 8/10/93 and before 2/18/09, you can potentially exclude up to 50% of the otherwise-taxable gain.

The maximum amount a shareholder can exclude from taxable gain on a sale of QSBS is the greater of 10 times the shareholder’s basis in the shares or $10 million. For example, if Sam acquires QSBS in December 2010 for $2 million and sells it in December 2017 for $20 million, 100% of his $18 million gain will be federal income tax-free, assuming all other QSBS requirements are met. Because he acquired the stock after September 27, 2010, Sam can exclude 100% of the gain subject to the rule that only the greater of $10 million or 10 times basis can be excluded. Ten times Sam’s $2 million basis is $20 million, making that the maximum amount of gain he can exclude if the requirements are met. Since his gain is only $18 million, the whole $18 million gain is excluded from federal income tax. If, instead, Sam acquires the QSBS in December 2008, just 50% of his gain ($9 million) can be excluded from tax under the QSBS rules.

Shares Must Be Held for More Than Five Years

To receive QSBS treatment, the shares must be held for at least five years from the date they are acquired to the date they are sold. If shares are converted or exchanged into other stock of the same company in a tax-free transaction, the holding period of stock received includes the holding period of the converted or exchanged stock. For shares received by gift or inheritance or as a transfer from a partnership, the holding period includes the period the donor, decedent or partnership held the stock. So for shares that have not yet been acquired, the 100% gain exclusion break will only be available for sales that occur sometime in 2024 at the earliest.

Shares Must Be Acquired at Original Issuance

The QSBS must have been directly acquired after 1993 at original issuance from a U.S. C-Corporation or its underwriter in exchange for money, property or services. In other words, shares purchased on the secondary market are not qualified QSBS. To prevent corporations from simply redeeming shares and reissuing stock at original issuance to qualify it as QSBS, rules provide that QSBS treatment may be unavailable if certain redemptions occurred within a specific time period before the selling shareholder received his or her shares. If the shares were acquired by gift from or upon the original shareholder’s death, as long as the original shareholder received the QSBS at original issuance, the shares are deemed to have been acquired at original issuance.

The Business’s Gross Assets Cannot Exceed $50 Million

Herein lies the first “S” in QSBS – small. The QSBS election was created to encourage investment in small businesses, and our current tax rules essentially define small as having no more than $50 million of assets from the company’s inception until immediately after the shareholder receives the QSBS. Put another way, the corporation needs to have no more than $50 million at all times before and immediately after stock issuance and needs to have conducted sufficient business activities at all times. The amount of assets the business has upon sale is irrelevant.

The Company Must Be Involved in a Qualified Active Trade or Business

QSBS treatment is only available if the majority of the business’s assets are used in connection with an active trade or business. Specifically, at least 80% of the assets must be used in the active conduct of business. Qualified businesses do not include rendering services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, other businesses where the principal asset is the reputation or skill of employees; banking, insurance, leasing, financing, investing, or similar activities; farming; production or extraction of oil, natural gas, or other minerals for which percentage depletion deductions are allowed; or the operation of a hotel, motel, restaurant, or similar business. Stock within these excluded industries cannot qualify as QSBS.

For the real estate and passive investor taxpayer, a business will fail the active trade or business test if it has too much portfolio stock or passive real estate. Specifically, no more than 10% of the value of the business’s assets (net of liabilities) can consist of real estate not used in connection with an active trade or business or of stock or securities in other corporations that are not subsidiaries of the business and not held as working capital.

The Shareholder Must Elect QSBS Treatment on His or Her Tax Return

Although the remaining QSBS qualifications are complex, fortunately the mechanics of making the QSBS election are relatively simple. A QSBS election is made on Schedule D of the shareholder’s tax return. Sufficient proof that the shares qualify as QSBS should be obtained from the business and retained for a minimum of three years following the filing of the relevant tax return.

Conventional wisdom says that it’s almost always best to operate a business as a pass-through entity (S-Corporation, partnership, or LLC). But conventional wisdom is probably wrong when an incorporated venture can meet the definition of a QSBC — because a QSBC offers the dynamic tax-saving duo of the flat 21% corporate rate and the potential for the 100% gain exclusion break when you sell your shares. As always, the rules are complicated and there are many nuances so it’s always advisable to consult with your tax professionals.