QSB Stock—A Hidden Gem
In recent years, startup companies have increasingly chosen to form as Subchapter S corporations or a limited liability company. There have historically been clear tax advantages from using one of these pass-through entities. However, the regular or Subchapter C corporation should not be overlooked, especially with the new lower tax rates applicable to Subchapter C corporations in light of the Tax Cuts and Jobs Act.
First, if you expect your company to raise capital from venture funds, you should be aware that most venture funds will only invest in Subchapter C corporations. Second, if your company meets the definition of a Qualified Small Business (“QSB”), your investors may have the opportunity to benefit from preferential federal tax treatment upon the sale of the business.
In order for stock in a company to be a QSB, the aggregate gross assets of the company must not have exceeded $50 million prior to, at the time of and immediately after the issuance of the stock; at least 80% of the assets, by value, of the company must have been used in active trade or business; the company must be a domestic “C” corporation (not an “S” corp or LLC); and the stock in question must be an original issuance stock (not from a secondary market or another stockholder) which was issued after 1993.
Section 1045 of the Internal Revenue Code allows investors who are not corporations to sell stock in a QSB corporation without recognizing any taxable gain if the investor rolls the gain into new QSB corporation stock within a 60-day period from the date of the sale. In order to benefit from this rollover treatment, the investor must have held the QSB stock for more than 6 months. The basis of the new QSB stock will be reduced by the amount of gain that was not taxed because of the 1045 roll-over. An investor seeking to benefit from the rollover must elect Section 1045 treatment on his or her federal income tax return.
Section 1202 of the Code allows investors who are not corporations to exclude from taxation 50%, 75% or 100% of their gain recognized from the sale or exchange of QSB stock held for 5 years or more, up to a maximum of $10 million or 10 times their basis in the stock, whichever is greater. If the investor has common stock that was converted from preferred stock, the holding period starts when the original preferred stock was first acquired. An individual who receives the stock by inheritance or as a gift is deemed to have held the stock since the original taxpayer’s acquisition date.
The amount that may be excluded under Section 1202 depends on when the stock was acquired. In general, if the holding period and other QSB requirements are met under Section 1202, at least 50% can be excluded. If the stock was acquired between February 18, 2009 and the enactment of the Creating Small Business Jobs Act on September 27, 2010, 75% of the gain can be excluded. For any stock acquired after the enactment of the Act, 100% of gain on the sale of QSB stock may be excluded from income.
All of these tax advantages are subject to several limitations and exceptions. Also, don’t assume that your state will follow the tax treatment for QSB stock. Entrepreneurs and investors are encouraged to work with your tax professionals to maximize the tax savings that may be available.
The blog content should not be construed as legal advice.