Many federal tax laws were enacted by Congress to help encourage taxpayers to take certain actions, such as donating to charity (to ease the burden of government) or buying a house (to help the real estate market). Such is the case with the tax break for qualified small business stock, or QSBS. Congress wanted to encourage people to create and invest in start-up businesses. Starting a small business, and investing in such a start-up, can be a risky proposition. Many start-ups don’t succeed.
But if you happen to have the good fortune to invest in one that makes it big — think certain technology start-ups — and your ownership interest in the business satisfies all the rules for QSBS, then you’ve hit the tax jackpot. Up to $10 million of your gain when you sell the stock is excluded from your income for federal income tax purposes.
The tax break for QSBS is extremely generous, so it shouldn’t come as a surprise that the definition of QSBS is very restrictive. There are many complex rules, including the type and structure of the company you invest in, how long to hold the stock, and much more. Also, the tax breaks differ depending on when you acquired the shares. So read further to see if you can take advantage of this increasingly popular tax-planning strategy.
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What is Qualified Small Business Stock (QSBS)?
There are a lot of pre-conditions for your stock to be eligible for QSBS treatment. First, only stock in C corporations qualifies. Sales of S corporation stock, partnership interests, or LLC units aren’t eligible.
Second, the shares must be acquired in an original issuance from the corporation. You can receive the stock in exchange for a direct investment of cash or property into the corporation. You can acquire shares through an initial public offering (IPO). Or you can acquire the stock from the corporation in exchange for services you provided to it. But stock bought from an existing shareholder or in a secondary market doesn't count. If you own QSBS stock and gift it to another individual, that person will also be treated as owning QSBS stock. The same rule applies to inherited QSBS stock.
Third, the corporation must be a qualified small business when you acquire the stock. The company’s gross assets at the time of the stock issuance and immediately thereafter cannot exceed $50 million. For this purpose, the gross assets calculation is based on the corporation’s cash and aggregate tax basis of assets, not fair market value.
Fourth, there is an active trade or business rule. At least 80% of the corporation’s assets must at all times be used in the active conduct of one or more qualified trades or businesses during the period the stock is held. This means that stock in holding companies or passive corporations isn’t QSBS.
Fifth, the stock of corporations in certain lines of business doesn’t qualify as QSBS. Those businesses include banking, leasing, insurance, financing, investing, hotels, restaurants, oil and gas, and farming. Also not eligible as qualified small businesses are personal service businesses in the fields of health, law, architecture, engineering, accounting, actuarial science, consulting, brokerage services, financial services, athletics, performing arts, or any business whose principal asset is the reputation or skill of one or more of its employees.
Determining whether a corporation is an ineligible personal service business isn’t always black and white. The IRS has issued private rulings in recent years with complex fact patterns, such as those involving a medical production corporation, an application services software firm, and a company that sold insurance products as a representative of other insurance companies.
Sixth, you must have owned the stock for at least five years before you sell it.
Tax Benefits When You Sell QSBS
The main tax benefit for many individual investors who own QSBS is up to 100% gain exclusion when you sell.
- Individuals who acquire QSBS after Sept. 27, 2010, and sell more than five years later can exclude 100% of their capital gain from the sale.
- The gain is also exempt from the alternative minimum tax (AMT).
- The amount of excludable gain is capped at the greater of 10 times your tax basis in the stock or $10 million.
For example, say you have a $3 million tax basis in QSBS that you’ve owned since 2014, and you sell the stock in 2023 for $5 million. Your full $2 million gain is excluded from your income, meaning that it’s tax-free for federal income tax purposes. It’s also not subject to the AMT.
You get a smaller tax break if you bought QSBS before Sept. 28, 2010. First, the gain exclusion is 75% for QSBS issued from Feb. 18, 2009, through Sept. 27, 2010, and 50% for QSBS issued from Aug. 11, 1993, through Feb. 17, 2009. Second, some or all of the non-excludable gain will be taxed at a higher 28% federal tax rate instead of the normal 20% tax rate generally applicable to capital gains (23.8% if you add in the 3.8% surtax on net investment income of upper-income individuals). The gain taxed at the 28% rate equals $10 million less the excludable gain. Third, 7% of the gain can be hit with an alternative minimum tax if the AMT otherwise applies to you.
Take this example. Say you acquired QSBS in 2007 for $1 million, and you sell the stock in 2023 for $17 million, resulting in a $16 million gain. $8 million of that gain is excluded, $2 million ($10 million - $8 million) is taxed at a 28% rate, and the remaining $6 million is taxed at a 23.8% rate. You may also have to pay AMT on part of the taxable gain.
Opposing Legislative Proposals to Change the QSBS Tax Break
Democratic and Republican lawmakers have differing views on the tax benefits of QSBS. President Biden and key congressional Democrats claim that the tax break is a boon for the wealthy and want to pare back the exclusion for sales of QSBS. In 2021, Biden and House Democrats tried to limit the 100% gain exclusion to individuals with adjusted gross incomes over $400,000. This proposal ultimately failed.
Republican tax writers in Congress take a different stance. They claim the tax benefit helps small businesses and want to bolster the break. A recent GOP-backed tax bill approved by the House Ways & Means Committee on partisan lines would expand the QSBS tax break in two major ways. First, it would allow stock in S corporations to qualify (right now, only stock in C corporations is eligible). Second, it would let individuals who hold QSBS stock between three and five years before selling the shares get partial gain exclusion on the sale.
None of the proposals is going to be enacted this year or next. Right now, they’re just wishful thinking, given the divided political climate in Washington, D.C. But you should keep an eye on them. It wouldn’t be surprising to see them again, maybe in 2025 or 2026, depending on which party takes the presidency and controls Congress after next year’s elections.
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