Tax Benefits of Qualified Small Business Stock (QSBS)

By July 22, 2020 Tax
QSBS | Tax Benefits of Qualified Small Business Stock

The early stages of a startup or small business can be a challenging and exciting process. Upon the successful development of your startup or small business, you, as a founder and shareholder, may look to capture significant financial gains by selling your share of the company. If that is the case, there is a powerful tax planning tool called Qualified Small Business Stock (“QSBS”) that can help you avoid a substantial amount of federal income tax.

What are the tax benefits of QSBS?

Under section 1202 of the Internal Revenue Code (IRC), non-corporate shareholders who hold QSBS for five years may exclude gains from selling QSBS from federal income tax. Qualified shareholders may exclude gains of up to $10 million or 10 times the shareholders’ basis (cash plus the fair market value of any property contributed to the corporation in exchange for the stock).

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What is the importance of the QSBS issuance date?

Before discussing the requirements of QSBS, it is important to note the QSBS issuance date. This date is important for three reasons:

  1. The five-year holding period requirement begins on the issuance date;
  2. It determines the exclusion percentage (50%, 75%, or 100%) for the gain from the sale of the QSBS;
  3. It establishes the date on which to measure the gross-assets test (discussed later).

For shareholder contributions of cash or property in exchange for stock, the issuance date is the date of such contributions. However, there are different rules when a shareholder receives stock in exchange for the performance of services.

For stock options, warrant, or convertible debt, the issuance date is the date of exercise or conversion. Unexercised options or warrants never qualify as QSBS. When you receive stock via gift, inheritance, or partnership distribution, the issuance date is the date on which the transferor acquired the stock.

Example 1: On January 1, 2015, Chris contributes $500 to Acme Co. in exchange for stock. The stock meets all the requirements of QSBS. On January 1, 2018, Chris gifts the stock to Brenda. In February 2020, Brenda sells all of her Acme Co. stock. Because Brenda is treated as having acquired the stock on January 1, 2015, the five-year holding period is met.

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What are the issuance date requirements?

C corporation requirement

On the issuance date, the issuing corporation must be a domestic C corporation, and the stock must be issued after August. 9, 1993. S corporation stock and partnership interests do not qualify for the QSBS exclusion. In addition, you cannot treat the stock of certain C corporations (such as a regulated investment company or a real estate investment trust) as QSBS.

Qualified small business requirement

On the issuance date, the corporation must satisfy two tests regarding its gross assets (the gross-assets test):

  1. From August 9, 1993 to the date of issuance, the tax basis of the total gross assets of the corporation must be less than $50 million.
  2. Immediately after the date of issuance, the total gross assets of the corporation must be less than $50 million.

If the gross assets of a corporation exceed $50 million, subsequent issuances of the corporation’s stock will not be QSBS, even if the gross assets fall below $50 million.

Example 2: Acme Co., a domestic C corporation, issues stock to Chris in 2017 when its gross assets are $5 million. In 2018, Acme Co. issues stock to Brenda, when its gross assets are $30 million. In 2019, Acme Co. issues stock to David, and immediately after the issuance, Acme Co.’s gross assets are $60 million. This is the first time Acme Co.’s gross assets exceeded $50 million.

The stock Acme Co. issued to Chris and Brenda is QSBS because Acme Co.’s gross assets did not exceed $50 million at the time nor immediately after the date of issuance. Stock issued to David is not QSBS because Acme Co.’s gross assets exceeded $50 million immediately after the date of issuance. No future issuance of Acme Co. stock will qualify as QSBS because it exceeded the $50 million threshold in 2019.

Total gross assets means the sum of the corporation’s cash and the total adjusted tax basis of other property. For purposes of QSBS, the adjusted basis of any property contributed to the corporation is equal to its fair market value (FMV) on the date of contribution.

Original issuance requirement

You must acquire QSBS at original issuance, which means that you must acquire the stock directly from the issuing corporation. Generally, you can satisfy this requirement when a shareholder (1) exchanges money or other property (not including stock), or (2) provides services for the corporation’s stock. If a shareholder acquired stock through the exercise of options or warrants or through the conversion of convertible debt, you may treat the stock as acquired at original issuance.

A shareholder who acquires stock from another shareholder will not be treated as having received the stock at original issuance.

When you receive stock via gift, inheritance, or partnership distribution, the transferee receives the stock in the same manner as the transferor. Likewise, if you acquire the stock at original issuance, the transferee will be treated as having done the same. If a partnership distributes stock to a partner, it must meet three criteria to qualify as QSBS:

  1. The stock must have been QSBS in the partnership’s hands (without regard to the five-year holding period requirement);
  2. The partner must have been a partner from the date the partnership acquired the stock through the date of the distribution; and
  3. The amount of the stock distribution that exceeds the partner’s interest in the partnership at the time the partnership acquired the stock cannot be treated as QSBS.

Example 3: On January 1, 2017, Chris contributes $2,000 to Acme Co. in exchange for stock. The stock meets the requirements of QSBS. On September 15, 2018, Chris gifts the shares to Brenda. Brenda is treated as having acquired the stock by contributing cash to Acme Co. — and thus is treated as having acquired the stock at original issuance.

Active business requirement

For consideration as QSBS, during substantially all of the shareholder’s holding period, the corporation must be a C corporation, and the corporation must use at least 80% (by value) of their assets in the active conduct of one or more “qualified trades or businesses.” Unfortunately, neither the IRC nor Treasury Regulations provide a clear-cut definition for “substantially all.” Similarly, the IRS and tax courts have offered no guidance on this term.

Qualified trades or businesses

For substantially all of the shareholder’s holding period, the corporation must use at least 80% of its assets in the active conduct of one or more “qualified trades or businesses.” A qualified business means any trade or business other than:

  • Trades or businesses that involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees;
  • Banking, insurance, financing, leasing, investing, or similar businesses;
  • Farming businesses (including the business of raising or harvesting trees);
  • Businesses involving the production or extraction of products of a character for which a depletion expense is allowed; and
  • Businesses that operate a hotel, motel, restaurant.

For this requirement, you must measure the value, not adjusted tax basis, of the corporation’s assets.

A corporation will fail the 80% test if more than 10% of the total value of its assets consists of real property not used in the active conduct of a qualified trade or business. For these purposes, owning, dealing in, or renting real property does not count as the active conduct of a trade or business.

Working Capital and Assets Held for Investment

According to Sec. 1202(e)(6), you cannot treat assets as used in the active conduct of a qualified trade or business if they are:

  1. Held as part of the “reasonably required working capital needs” of a qualified trade or business, or
  2. Held for investment and are reasonably expected to be used within two years to finance research and experimentation in a qualified trade or business or increases in the working capital needs.

Neither the IRC nor the Treasury Regulations define a corporation’s “reasonably required working capital needs.”

Sec. 1202(e)(6) also provides that, after a corporation has been in existence for at least two years, you cannot treat more than 50% of its assets as used in the active conduct of a qualified trade or business via the working capital exception.

Example 4: Acme Co. is formed in 2016 and begins operating a qualified trade or business. In 2019, at a time when Acme Co. has assets being used in the active conduct of its trade or business of $1 million and no other assets, Acme Co. raises $19 million through two rounds of financing. $16 million of the $19 million remain as cash at year end, with the other $3 million having been used to purchase equipment and machinery. Because Acme Co. is more than two years old, only 50% of the $20 million of total assets ($10 million) can be treated as being used in the active conduct of a trade or business by virtue of the working capital exception. In applying the 80% test at the end of 2019, Acme Co. has assets used in the active conduct of a trade or business of $14 million ($10 million of working capital and $4 million of other assets) and total assets of $20 million. As a result, Acme Co. fails the 80% test.

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What are the exclusion percentages and limitations?

Taxpayers can exclude the gain from the sale or exchange of QSBS from taxable income so long as they hold the QSBS for at least five years. Note that there are some rules and limitations regarding the exclusion percentage and amount.

The exclusion percentages for QSBS are as follows:

  • 50%, if acquired between August 9, 1993 and February 17, 2009.
  • 75%, if acquired between February 18, 2009 and September 27, 2010.
  • 100%, if issued on or after September 28, 2010.

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What are the per-issuer limitations?

Before you can apply the corresponding exclusion percentage, your gain amount is subject to two limitations: (1) a cumulative limitation, and (2) an annual limitation. You must apply these rules on a corporation-by-corporation and shareholder-by-shareholder basis. Each year that a shareholder sells QSBS, the total gain that may be taken into account for each issuing corporation is limited to the greater of:

  • $10 million less the total amount of gain previously excluded from such QSBS (the “cumulative limitation”), or
  • Ten times the adjusted basis of the QSBS issued by the corporation and disposed of by the shareholder during the taxable year (the annual limitation).

Example 5:  Chris contributes $200,000 to Acme Co. in 2007 in exchange for 2,000 shares of stock. The stock meets the definition of QSBS. In 2017, Chris sells 1,000 shares of the Acme Co. stock for $6 million. The total gain on the sale is $5,900,000 ($6 million less $100,000 of allocable basis in 1,000 shares). The limitations for 2017 are as follows:

  • The cumulative limitation of $10 million.
  • The annual limitation of $1,000,000 (10 times the basis of the stock sold during the year of $100,000).

As the cumulative limitation is greater than the annual limitation, Chris may take the entire $5,900,000 of gain when applying the exclusion percentage. Because the Acme Co. stock Chris sold in 2017 was acquired in 2007, the applicable exclusion percentage is 50%; thus, Chris may exclude $2,950,000 of gain.

In 2019, Chris sells the remaining 1,000 shares of Acme Co. stock for $7,000,000. The total gain on the sale is $6,900,000. The limitations for 2019 are as follows:

  • The cumulative limitation of $4,100,000 ($10 million reduced by the $5,900,000 taken into account in 2017).
  • The annual limitation of $1,000,000 (10 times the basis of the stock sold during the year of $100,000).

As the cumulative limitation is greater than the annual limitation, $4,100,000 of gain will be applied to an exclusion percentage of 50%, resulting in an exclusion of $2,050,000.

Example 6: Chris contributes $3 million to Acme Co. in 2012 in exchange for 3,000 shares of Acme Co. stock. The stock meets the definition of QSBS. In 2018, Chris sells 800 shares of the Acme Co. stock for $13 million. The total gain on the sale is $12,200,000 ($13 million less $800,000 of allocable basis in 800 shares). In 2018, the limitations are as follows:

  • The cumulative limitation of $10 million.
  • The annual limitation of $8 million (10 times the basis of the stock sold during the year of $800,000).

As the cumulative limitation is greater than the annual limitation, Chris may take $10 million of the gain into account when applying the exclusion percentage. Because the Acme Co. stock Chris sold in 2018 was acquired in 2012, the applicable exclusion percentage is 100%; thus, Chris may exclude $10 million of gain.

In 2019, Chris sells the remaining 2,200 shares of Acme Co. stock for $40 million. The total gain on the sale is $37,800,000. For 2019, the limitations are as follows:

  • The cumulative limitation of $0 ($10 million reduced by the $10 million taken into account under in 2018), or
  • The annual limitation of $22 million (10 times the basis of the stock sold during the year of $2,200,000).

Thus, even though Chris excluded $10 million of gain in 2018, Chris may take into account an additional $22 million of gain in 2019 under the annual limitation. Chris applies the applicable exclusion percentage of 100%, resulting in an exclusion of $22 million.

Section 1202(b) allows a shareholder to aggregate all basis and gain related to the sale of stock in the same corporation during a given tax year for purposes of applying the cumulative and annual limitation.

Example 7: In 2011, Chris acquired 500 shares of QSBS in Acme Co. with a basis of $500,000 (the low-basis shares). In 2012, Chris acquired another 500 shares of QSBS in Acme Co. with a basis of $2 million (the high-basis shares). In January 2018, the shares are worth $30 million. If Chris sells only the high-basis shares in 2018, he recognizes gain of $13,000,000 (1/2 of $30,000,000 value less $2 million basis). The limitations are as follows:

  • $10 million (the cumulative limit), or
  • $20 million (10 times the basis of $2 million).

Thus, Chris may exclude from taxable income $13,000,000 of gain.

In July 2019, Chris sells the low-basis shares, which results in a gain of $14,500,000 (1/2 of $30,000,000 value less $500,000 basis). The limitations are as follows:

  • $10 million (the cumulative limit), or
  • $5 million (10 times the basis of $500,000).

For the July 2019 transaction, Chris may exclude from taxable income $10 million of gain. The total exclusion over the two years is $23 million.

Example 8: The facts are the same as in the preceding example, except Chris sells both blocks of shares in 2018. Section 1202(b) allows Chris to combine the basis and amount realized from both blocks of shares in computing the cumulative and annual limitations. The total basis of the shares is $2,500,000, and the total gain is $27,500,000. The limitations are as follows:

  • $10 million (the cumulative limit), or
  • $25 million (10 times the aggregate basis of $2.5 million).

As a result, Chris may exclude from income $25 million of gain. By selling all of the shares in one year and including the basis of the 1,000 shares, Chris excludes from income an additional $2 million ($25 million less $23 million) of gain when compared with the previous example.

QSBS held in a passthrough entity

When a partnership or S corporation holds QSBS, partners or shareholders may exclude their share of any gain the passthrough entity recognized on the disposition of the QSBS, subject to the following requirements and limitations:

  1. The stock must meet all QSBS requirements.
  2. The passthrough entity must hold the QSBS for at least five years.
  3. A partner or shareholder may only exclude gain if the partner or shareholder held an interest in the partnership or S corporation on the date the entity acquired the QSBS and at all times before the entity sold the QSBS.
  4. The partner or shareholder may exclude only the amount of gain the partner or shareholder would have been allocated based on his or her ownership interest at the time the entity acquired the QSBS.

Example 9: Chris acquired a 40% interest in XYZ Partnership on Jan. 1, 2013. In May 2013, the partnership contributed $300,000 to Acme Co. in exchange for Acme Co. stock. In 2015, Chris increased his ownership in XYZ Partnership from 40% to 50%. In 2019, at a time when the Acme Co. stock meets the definition of QSBS, XYZ Partnership sells all of the Acme Co. stock for $1,000,000, recognizing gain of $700,000, $350,000 of which is allocated to Chris.

Because (1) the Acme Co. stock was QSBS in the hands of XYZ Partnership, and (2) Chris was a partner in XYZ Partnership at the time it acquired the QSBS and through the sale of the QSBS, Chris is eligible to exclude a portion of his $350,000 gain. Chris is limited, however, to taking into account the amount of gain Chris would have been allocated based on his original interest in the partnership, which is 40%. Thus, $280,000 (40% times $700,000 of gain) may be eligible for the exclusion. Because the applicable percentage for QSBS acquired in 2013 is 100%, Chris may exclude the entire $280,000 of gain fron his taxable income. Chris must include the remaining $70,000 of gain allocated from XYZ partnership in his income.

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How does the conversion of an existing business affect my QSBS?

S corporation to C corporation

As discussed earlier, for stock to qualify as QSBS, the issuing corporation must be a C corporation on the date of issuance. Even if an S corporation meets all the requirements of a qualified small business, the S corporation stock can never qualify as QSBS, regardless if it later converts to a C corporation.

Example 10: In 2015, Chris and Brenda form Acme Co., an S corporation, by transferring $500 each to the corporation in exchange for stock. The corporation meets all the requirements of QSBS except that the corporation is an S corporation, not a C corporation. Effective Jan. 1, 2018, Acme Co. revokes its S election. The stock held by Chris and Brenda cannot qualify as QSBS, because at the time the stock was issued, the corporation was not a C corporation.

For the stock to qualify as QSBS, the S corporation must revoke or terminate its election, meet all of the requirements of a qualified small business, and issue new stock.

Example 11: Continuing the previous example, assume that in January 2019, Chris and Brenda contribute $2,000 each to Acme Co., now a C corporation, in exchange for shares. If Acme Co. satisfies the other requirements of QSBS, the stock issued in 2019 will qualify as QSBS. Thus, if Chris and Brenda hold the stock for five years, they will be eligible for a 100% exclusion on any resulting gain, subject to the cumulative and annual limitations.

Partnership to C corporation

Revenue Ruling 84-111 provides three methods for a partnership to convert to a C corporation. Each method allows the partners-turned-shareholders to qualify for the benefits of QSBS. In general, partners will be treated as receiving stock at original issuance. Depending on the conversion method, the stock’s holding period will begin on the date the partnership transfers the assets to a newly formed corporation (the assets up method) or the liquidation date of the partnership (the assets over method). The basis in the stock will be the partner’s share of the FMV of the assets transferred to the corporation by the partnership. As a result, only future appreciation on the stock issued after the date of conversion will be eligible for QSBS benefits.

For purposes of the $50 million gross-assets test on the date of a partnership conversion, the basis of the assets of the corporation must be greater than or equal to their FMV; the basis cannot be below their FMV. It is important to realize that this could cause a partnership with high-value intangible assets to fail the gross-assets test, thereby disqualifying the corporation’s stock as QSBS.

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Are there other options if I do not meet the holding period requirement?

In short, yes. Taxpayers that do not hold QSBS for at least five year may defer some or all of the federal gain on the sale of the stock by reinvesting the gain into other QSBS. To benefit from this gain deferral (called a “Section 1045 rollover”), there are some rules:

  1. The investor must have owned the QSBS for at least six months on the date of sale, and
  2. They must reinvest some or all of the proceeds from the sale into newly acquired QSBS within 60 days of the sale of the prior QSBS.

The holding period and adjusted tax basis from the original QSBS will rollover into the newly acquired QSBS, effectively deferring the federal income tax recognition event.

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How can Squar Milner help?

When selling your company shares, you will need a team of professionals that can help navigate your exit strategy and maximize your tax savings. At Squar Milner, we have an experienced group of tax professionals dedicated to helping you achieve your financial goals by assessing and optimizing your tax-saving strategies such as QSBS. Our goal is to assist you during a significant financial milestone for you and your company. Contact us today!

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KEY CONTACT

Anthony Chow
Principal, Tax Services

achow@squarmilner.com

Disclaimer: This material has been prepared for informational purposes only, and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional tax planner or financial planner. All information is provided “as is,” with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.

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