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Qualified Small Business Stock

Arin V., EA , MBA
Arin is an Enrolled Agent (EA), authorized to represent taxpayers in front of the IRS, and holds a BA and MBA (Management) degree from California State University, Northridge.
Are you a startup founder or entrepreneur? If so, did you know that under certain circumstances, if you were to sell your stock in the company you founded, that you could exclude up to 100 percent of the gain from federal income tax?

Indeed, for a qualifying transaction, the total excludable gain is limited to the greater of $10 million or 10 times the adjusted basis of the investment. Your basis, in this case, would be equal to the amount of money you put in, plus the fair market value of any property contributed to the corporation, in exchange for the stock you received.

But what is qualified small business stock (QSBS)? Simply put, QSBS is stock in a C corporation that meets the conditions of being a qualified small business corporation.

To qualify for this amazing tax break, certain criteria will have to be met, which includes the following:

  • The company issuing the stock needs to be a C corporation
  • The company’s assets need to be $50 million or less, from August 9, 1993, all the way until after the sale of the stock
  • The company needs to be an active business (which means, not a holding company) that is also not a personal services corporation (such as banking, insurance, financing, leasing, or a restaurant or hotel). This means, then, that typical startups such as technology startups, not to mention manufacturing businesses, would qualify
  • The stock has to be acquired in exchange for money, property, or as pay for services provided to the company

And what is the specific tax treatment and implications of QSBS for a shareholder/founder? Just like any other investment, it depends on when the stock was acquired and how long it was held for.

If you acquired the stock after September 27, 2010 and held it for more than five years, there is no tax on the gain. This means that there is no income tax, no alternative minimum tax (AMT), nor the 3.6 percent net investment income tax (NIIT). However, if you held the stock for more than one year but less than five years, then it would be treated like a normal long-term capital gain. If you held the stock for one year or less, the gain would be taxed at ordinary income tax rates.

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If you acquired the stock between February 18, 2009 and September 27, 2010, and you held it for more than five years, then 75 percent of the gain would be excludable. However, seven (7) percent of the gain would still be subject to AMT.

Finally, if you acquired the stock before February 18, 2009, the exclusion on the gain is limited to only 50 percent, and seven (7) percent of the gain would still be subject to AMT.

Therefore, if you are a startup founder looking to raise capital, QSBS may be a great way to attract a co-founder and/or angel investor. How so? Because the exclusion on the gain applies to individuals and not corporations, if you had a co-founder who could contribute capital to the business, they would be in a position to potentially benefit from this tax break. So too would an angel investor who believed in your vision.

As you may have imagined, this is also a good way to attract valuable employees. Since you are able to issue QSBS in exchange for services performed, you can use equity to compensate superstars at your startup. In this way, too, employees will have some skin in the game and will be more dedicated to the long-term success of the company.

If you are a startup founder or entrepreneur and believe you may qualify for this terrific tax break, please get in touch today to discuss your options. We can help you structure things properly so that not only are you running your business in a tax-efficient manner, but also, if you exit one day, you will be in a position to save a huge chunk of money on taxes.

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