Qualified Small Business Stock Plan

Small business owners and other individuals who invest in small businesses have several tax benefits available to them that can assist in lowering their exposure to tax and save them money. One of the most advantageous tax benefits is the Qualified Small Business Stock (QSBS) rules, codified in §1202 of the Internal Revenue Code (IRC).

What is §1202?

Section 1202 of the IRC was enacted by Congress to help small businesses and encourage investment into small business stocks. To incentivize investment in small business, §1202 allows a taxpayer to exclude a portion of any gain on QSBS from their gross income. To qualify for the exclusion of gain, the stock must be QSBS from a “qualified small business.”

What is a “Qualified Small Business”?

To qualify for the benefits of §1202, the business must be a qualified small business (QSB), per the IRC. To be considered a QSB, the business must meet the following requirements:

• Be a domestic C Corporation;
• The gross assets of the corporation may not, either before or after issuance of the stock, exceed $50 million;
• The corporation must file required reports to the IRS and its shareholders;
• The “active business requirement” must be met, made up of the following requirements:
  • at least 80% of the assets (by value) must be used by the corporation in active conduct of one or more qualified businesses; and
  • the corporation must be an “eligible corporation”—i.e., any domestic C Corporation except for domestic international sales corporations, regulated investment companies, real estate investment trusts, real estate mortgage investment conduits, or cooperatives.

If the small business is a part of a group of businesses owned by a common parent corporation, the group of businesses will be treated as a single corporation to determine if it is a QSB. If the parent corporation owns more than 50% of the subsidiary corporation, it will be included as part of the controlled group. On the other hand, if the parent corporation owns 50% or less of the business, the subsidiary corporation will not be grouped with the other businesses.

The status as a qualified small business is not limited to a small subset of industries. Rather, it applies to a broad range of industries, including healthcare, legal services, accounting and actuarial services, banking and investing services, hotels, restaurants, and even farming, among many others.

What is “Qualified Small Business Stock”?

The stock from the qualified small business must be qualified stock. The following requirements must be met for stock to be considered QSBS:

• The stock must have been issued after the enactment of §1202—i.e., after August 10, 1993;
• The issuing business must be a C Corporation;
• The issuing business must be a QSB;
• The issuing business meets the “active business requirement,” detailed above;
• The original issuance requirement is met, which requires that the stock is acquired by the taxpayer at its original issue—not a secondary market—in exchange for money, property (not including stock), or as compensation for services provided to the corporation (except for underwriting services for the specific stock).

Additionally, stock acquired by converting stock of one corporation to the stock of another corporation, if it is a QSB, will be treated as QSBS. The newly converted stock will be treated as having been held by the taxpayer for the same period that the prior stock was held for.

Lastly, note that C Corporations that hold the stock of a QSB are not eligible to utilize the QSBS tax benefits.

What Are the Tax Benefits Available for QSB Stockholders?

If the requirements above are met—the business is a QSB and the stock issued is QSBS—the taxpayer will be eligible to utilize §1202’s gain deferment. Specifically, §1202 generally allows the taxpayer to exclude 50% of the gain from the sale of QSBS if it was held for more than 5 years.

The percentage of gain that can be excluded under §1202 has changed over time. For QSBS purchased in 2009 and 2010, the applicable percentage is 75%.  QSBS purchased after 2010 has an applicable percentage of 100%. Taxpayers should review when they acquired the QSBS to determine the applicable exclusion amount they are eligible for.

The amount of gain allowed to be excluded is capped at the greater of either: (1) $10 million, or (2) 10 times the taxpayer’s basis in the QSBS. This limitation is applied on a per-issuer basis, meaning that the cap applies to QSBS per corporation rather than as a gross limit on all QSBS for all corporations the taxpayer has invested in.

Section 1045 Gain Rollover for QSBS

Under §1045 of the IRC, taxpayers who have capital gain from the sale of QSBS, that was held for more than six months, may elect to rollover that gain if new QSBS stock is purchased within 60 days of the sale of the original QSBS. If the amount realized from the sale of the original QSBS exceeds the cost of the QSBS obtained, the difference will be treated as gain on the sale of the original QSBS.

To elect to rollover gain under §1045 of the IRC— which lays out the process for the exchange of one QSBS for another QSBS— the taxpayer must make the election on the filing due date of their income tax return in the year the original QSBS is sold. Notably, the gain rollover does not apply to any gain that is treated as ordinary income for tax purposes.

How Are Losses Applied for QSBS?

In the event that the sale of QSBS results in a loss, §1244 of the IRC—which deals specifically with losses on QSBS— may apply. To qualify for §1244, the following must be met:

• Must be stock issued by a “small business corporation.” A corporation is considered a small business corporation “if the aggregate amount of money and other property received by the corporation for stock, as a contribution to capital, and as paid-in surplus, does not exceed $1 million;”
• The stock must be issued in exchange for money or property other than stock and securities;
• The corporation must, during the five most recent tax years ending before the date the loss on stock occurred, have derived more than 50% of its income from non-investment income, like prices, scholarships, awards, or gambiling winnings. Investment income includes income such as “royalties, rents, dividends, interests, annuities, and sales or exchanges of stocks or securities.”

If §1244 applies, the loss will be treated as an ordinary loss. While a loss on stock generally results in a capital loss alone, §1244 allows investors in QSBS who experience a loss on the sale of the stock to categorize the loss as an ordinary income loss. This means the loss can be used to offset ordinary income items, such as wages, dividends, or any other ordinary income line item.
Taxpayers should be aware that the IRS’ wash sale rules may apply if the taxpayer replaces the original QSBS with new QSBS within either 30 days prior or 30 days of the sale of the original QSBS. In that case, the loss would most likely be disallowed.

Next Steps

Investors and small business owners can benefit greatly from the numerous tax benefits offered on QSBS transactions. Whether the taxpayer has a gain, a loss, or is replacing one QSBS with another, the tax code provides benefits for any of these situations. Ensure your stock strategy is tax-advantaged.