What if we told you that you could invest in a small business and not pay taxes on the gains? Well, your dream can be a reality, provided you make some key moves before you write that first check. Investing in a qualified small business not only offers great growth opportunities for local startups, but also means more money in your bank account. Investors who purchase and hold stock for more than five years in qualified small businesses are excluded from paying taxes on stock gains. Discover the tax and financial planning strategies of investing in qualified small businesses below.
What is a Qualified Small Business (QSB)?
A Qualified Small Business (QSB) is a domestic C-corporation whose assets don’t go over $50 million on or after the issuance of stock. While this tax incentive offers great benefits to both investors and small businesses, the business must be part of a qualifying industry. Small businesses in technology, retail, wholesale, and manufacturing sectors qualify, while those in the hospitality industry, personal services, financial sector, farming, and mining are excluded. Additionally, the IRS code defines a qualified small business stock as:
- It was originally issued after August 10, 1993, in exchange for money, property (not including stocks), or as compensation for a service rendered.
- On the date of stock issue and immediately after, the issuing corporation had $50 million or less in assets.
- The use of at least 80% of the corporation’s assets is for the active conduct of one or more qualified businesses.
- The issuing corporation does not purchase any of the stock from the taxpayer during a four-year period that begins two years before the issue date.
- The issuing corporation does not significantly redeem its stock within a two-year period beginning one year before the issue date. A significant stock redemption is redeeming an aggregate value of stocks that exceed 5% of the total value of the company’s stock.
Requirements for Qualified Small Business Stock Gain Exclusion
Section 1202, enacted in 1993, offers a tax incentive for investors with an opportunity to exclude some or all of the gain realized from investments made in qualifying small businesses. In order for an investor to claim the tax benefits of the stock being qualified the following qualifications must be met:
- The investor must not be a corporation.
- The investor must have acquired the stock at its original issue and not on the secondary market.
- The investor must have purchased the stock with cash or property or accepted it as payment for a service.
- The investor must have held the stock for at least five years.
- At least 80% of the issuing corporation’s assets must be used in the operations of one or more of its qualified trades or businesses.
When originally enacted, the gain exclusion was limited to 50% of the gain, which was then increased to 75% for stock acquired after February 17, 2009, and before September 28, 2010. Finally, the gain exclusion was increased to 100% for stock acquired after September 27, 2010, with limits. The exclusion is limited to the greater of $10 million or 10 times the aggregate adjusted basis of the stock at the time of the issuance.
While the qualifications for a small business stock gain exclusion can be tricky to meet, it’s a great option for investors looking to provide funding to startups with the advantage of tax savings. The gains that are excluded under section 1202 are also exempt from the 3.8% tax applied to most net investment income.
Additionally, pass-through entities can take advantage of the stock gain exclusion as the gain exclusion applies at the ultimate investor level. The total gain share exclusion may be significantly higher for a pass-through entity that sells stock of a qualified small business. If a partnership with 5 partners, all with equal ownership, sells QSB stock of $50 million, each partner will be able to exclude their share of up to $10 million (meaning all $50 million of the gain is excluded at the ultimate investor level).
Example of Qualified Small Business Stock Gain Exclusion
With all the rules about qualified small business stock gain exclusions, it can be difficult to imagine the type of investment that would ultimately qualify. Here’s an example of a successful QSB stock gain exclusion. A taxpayer who is single and earns $450,000 in ordinary income (therefore reaching the highest tax bracket) sells QSB stock that was purchased on November 1, 2010. He held the stock for more than five years and acquired the stock at its original issue (obtaining it directly from the corporation as a qualified shareholder). He realizes a profit of $40,000 after selling the stock. Because he has met all qualifications mentioned above, 100% of the stock gain is excluded, making the federal tax due on the $40K gain $0.
The qualified small business stock gain exclusion can be a great addition to your tax and financial planning strategy—but it does require advanced planning. We recommend consulting with your trusted strategic financial advisor to ensure all qualifications will be met in order to take full advantage of the exclusion. We would be honored to assist you with your financial planning and discovering the benefits of investing in QSBs. Contact us to schedule a consultation with one of our financial advisors.