Imagine you own stock in a company whose value increases significantly, you sell it, and you don’t have to pay any taxes on the profit. That’s possible with qualified small business stock (QSBS). Also known as Section 1202 stock, named after the relevant section of the Tax Code, QSBS can be a powerful tool for the right company, like a tech startup.
### What is Qualified Small Business Stock?
The tax benefits of QSBS are substantial, but the requirements are quite specific. Here are the main conditions:
– The issuer must be a U.S.-based C corporation, not an S corporation.
– The corporation’s assets must be $50 million or less from August 9, 1993, onward (or the lifetime of the company if it was established later), both before and after the stock is issued.
– The corporation must actively conduct business, not just hold assets, during the entire period the stock is held.
– The corporation must not engage in personal services, banking, insurance, financing, leasing, investing, farming, mining, or operating a hotel, motel, or restaurant. Permissible businesses include manufacturing, retailing, technology, and wholesaling.
– Both the corporation and the shareholder must agree to provide specific documentation concerning the stock.
– The stock must be bought with money, property, or in exchange for services provided to the corporation. If someone acquires QSBS from another person, they typically can’t benefit from the tax break on the sale of the stock.
### Tax Treatment for Shareholders
How the tax break works for shareholders depends on how long they hold the QSBS and when they acquired it:
– **Stock acquired after September 27, 2010:** If held for more than five years, the gain is free from income tax, alternative minimum tax, and the 3.8% net investment income tax. If held for more than one year but less than five years, the gain is taxed as a capital gain at up to 20%. If held for one year or less, the gain is treated as short-term capital gain, taxed as ordinary income.
– **Stock acquired between February 18, 2009, and September 27, 2010:** If held for more than five years, 75% of the gain is excluded from gross income, though 7% of the gain is subject to alternative minimum tax.
– **Stock acquired before February 18, 2009:** Only 50% of the gain is excluded from gross income, with 7% subject to alternative minimum tax.
In all scenarios, the excludable gain is capped at either $10 million or 10 times the adjusted basis of the investment, whichever is greater.
If the stock hasn’t been held long enough to qualify for the best tax treatment, you can defer the gain by reinvesting in another qualified small business within 60 days of the sale, provided the stock has been owned for more than six months.
### Strategies for Using QSBS
Given the potential for big, tax-free profits, companies that qualify should think strategically about using QSBS:
– **Attracting Investors:** Startups and expanding businesses might use QSBS to raise capital. The tax exclusion benefits individuals, not corporations, so potential investors are individuals and partners in partnerships. A partnership can acquire the stock, allowing a partner (individual, not a corporation) to benefit from the exclusion if they were a partner when the stock was purchased and throughout its holding period. The exclusion matches the partner’s percentage interest in the partnership at the time of acquisition.
– **Rewarding Employees:** QSBS can be issued in exchange for services, making it a valuable tool for startups or cash-strapped companies to compensate employees. It also encourages employees to stay and contribute to the company’s success. However, issuing unrestricted QSBS does incur payroll tax for the company. The stock’s value, equivalent to the compensation for services performed, is taxable to employees, subject to income tax withholding, Social Security, Medicare (FICA) taxes, and FUTA (federal unemployment) tax. Withholding must be in cash, usually taken from other wages or paid separately by the employee or company. Income tax withholding on stock can be done by adding its value to regular wages or using a flat 25% rate (39.6% if the stock value exceeds $1 million).
### Conclusion
If you have a C corporation or are considering forming one, and you’re in an eligible industry, think about using qualified small business stock to raise capital or reward key employees. Consult a tax advisor to ensure all conditions for being a qualified small business are met before proceeding.
