The Section 1202 “qualified small business stock” exclusion, also called the QSBS exclusion, allows you to avoid taxes on the sale of your business.
Quite honestly? It doesn’t get better than this… But let’s go over the details.
The Section 1202 Exclusion in a Nutshell
The Section 1202 exclusion works simply. You avoid paying capital gains taxes on the sale of the stock you hold in your small corporation. (The corporation needs to be a regular “C” corporation. Not an “S” corporation.)
Example: You start your corporation by investing $10,000. Later you sell your stock in the corporation for $10,000,000. The $9,990,000 gain you enjoy? As long as you fulfill the Section 1202 requirements, you pay zero capital gains tax.
And it gets even better, if you can believe it. The QSBS stock exclusion also lets you avoid NIIT (net investment income tax) and AMT (alternative minimum tax.)
Amazing, right? Almost unbelievable…
So how do you qualify for this wonderful tax treatment? You need to meet six requirements.
Requirement #1: Five Year Holding Period
You need to hold your qualified small business stock (QSBS) for at least five years.
Another thing to note? Another section of tax law, Section 1045, says you can sell QSBS earlier than 5 years and “roll over” the gain of the disposition into the QSBS of a different issuer, provided you held the stock for at least 6 months.
So you have some flexibility.
Also, if you’re not a corporation? Not necessarily a problem. If you currently own and operate a sole proprietorship or partnership, you can incorporate your existing business to obtain your QSBS.
If you incorporate an existing sole proprietorship or partnership, however, the five year time clock starts at the point you incorporate.
Caution: Be careful if you’re not already a “C” corporation. You can probably incorporate an existing business without paying taxes using a Section 351 exchange. (Your QSBS stock basis equals the market value of the assets on the day of the Section 351 transfer.) But switching to a “C” corporation after starting a venture may mean additional taxes on the unrealized “non-exclude-able” gain at the point of incorporation. Also, consider the possibility that an un-incorporated business selling assets may receive a higher price from a buyer as compared to a corporation selling stock. (The higher price would reflect the tax savings the buyer enjoys by depreciating purchased assets.)
Requirement #2 Originally Issued Stock
You can only use the Section 1202 exclusion if you acquire original issue stock. In other words, stock issued by the corporation.
If you buy stock from some other stockholder–so on the secondary market–you can’t use Section 1202 for that stock.
Requirement #3: 80% of Corporate Assets Actively Used
For stock to receive QSBS treatment, the corporation must use at least 80% of its assets in the active conduct of its trade or business. And if that doesn’t happen?
If 20% or more of the corporation’s assets are passive “income generating assets” like investment real estate, securities or excess cash (over and above what’s required for working capital), shareholders lose the QSBS opportunity.
Requirement #4: Assets Cannot Exceed $50 million
Section 1202 limits the size of a corporation whose shareholders can use the QSBS exclusion. Cash plus the adjusted tax basis of property held by the corporation cannot exceed $50 million.
Note: If your company’s assets grow over $50 million after the the stock is issued, initial shares of QSBS won’t be affected, but the corporation will never be allowed to issue QSBS again, even if the assets dip back below $50 million.
Requirement #5: Limit Exclusion to $10 million or 10 Times QSBS Basis
The Section 1202 tax law specifies a couple of limitations. First, the law limits the excluded gain to the greater of $10 million or 10 times the aggregate adjusted basis of the QSBS.
Example: The fair market value, or “QSBS” basis, of the assets you contribute to your corporation equal $5 million. You sell your business in 10 years for $55 million. You are able to exclude gain up to the greater of $10 million or 10 times your $5 million basis, which is $50 million. Your tax-free income exclusion in this case equals the full $50,000,000. Sounds pretty good, right?
Requirement #6: Eligible Industry
A second limitation: Not all industries qualify for the qualified small business stock benefit.
Trades involving the performance of services in health, law, engineering, architecture, accounting, performing arts, consulting, athletics, financial services, actuarial sciences, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees, for example, do not qualify for QSBS.
Note: Those familiar with our Section 199A, Qualified Business Income Deduction, blog post may notice the similarity to the definition of a “Specified Service Trade or Business.”
Tip: Check out the full list of ineligible industries in Section 1202(e)(3).
It’s not surprising if you have never heard of QSBS before. Until recently, high corporate tax rates made C Corporations unattractive to small business owners.
Furthermore, it’s worth noting that the 100% gain exclusion on QSBS wasn’t always available. (The exclusion initially ran 50% when Section 1202 appeared in 1993.)
However, with corporate tax rates running at a flat 21% and the exclusion currently offering 100% tax avoidance, Section 1202’s exclusion may be worth a closer look.
Maybe it’s time to call your tax adviser?