Taxpayers can exclude income on the sale of qualifying small company shares (QSBS) under Internal Revenue Code Section 1202. Section 1202 encourages investment in small businesses, and investors may get spectacular profits. When a stakeholder other than a corporate business sells QSBS that was bought after September 27, 2010 and was held for over five years, the investor might deduct up to $10 million or 10 times their basic price of the stock from taxable profits. This provides amazing investment opportunities to investors and allows businesses to attract substantial funding. However, it’ll be a shame if the business or the investors misses out on tax benefits by falling into one of the QSBS pitfalls, and that’s why they must read this article.
This article explains qualified small business stock, benefits, and requirements. It further explains how to determine the qualified stocks and describes some common QSBS pitfalls and mistakes investors make with QSBS.
What is QSBS?
The qualified small business stock of a company meets the requirements for a “qualified small business” (QSB) under Internal Revenue Code Section 1202 (QSBS). The common name for QSBS is Section 1202 stock. The stock must completely satisfy the requirements of IRC Section 1202 for shares of qualifying small business stock. We will discuss the criteria later in this article.
How does QSBS work?
Through Section 1202’s capital gain exclusion, the Qualified Small Business Stock (QSBS) program of the US government makes a substantial effort to promote investment in small businesses. If you own QSBS, you may avoid paying taxes on your earnings when you engage in qualifying firms. The QSBS capital gain exclusion was created to help firms convince and keep key employees via employee stock options and attract investors with large tax savings on offer. Investors benefit greatly from the possibility of low or no income taxes.
The Revenue Reconciliation Act’s 1993 provision, Section 1202, was designed to encourage non-corporate taxpayers to invest in certain small businesses. The Small Business Jobs Act of 2010 and the American Recovery and Reinvestment Act of 2009 later changed the exclusion, eventually boosting it to the current 100% exclusions on capital gains of up to $10 million or 10x the initial share price paid through QSBS. The Protecting Americans from Tax Hikes Act made any QSBS earned after September 27, 2010, irreversible in 2015.
Benefits of QSBS
To help firms attract investors with tax advantages and hire and retain key individuals with employee stock options, section 1202 created the QSBS exemption. Section 1202 has several advantages, particularly for investors who gain greatly from the likelihood of little or no taxes on profits owing to the exclusion of capital gains.
The fact that issuing QSBS provides a big selling point when looking for funding could make it helpful even if there are no direct tax benefits for the small business. Additionally, since the law enables companies to issue QSBS as compensation for services, it may be used as a benefit to attract top personnel or to reward and retain employees.
Stock issuance requirements
The following conditions must be satisfied on the day that OSBS is issued.
C corporation requirements
When any stock is issued, the issuing company must be a national C corporation. As a result, regardless of whether the election later expires, shares issued while a company was an S corporation will never be QSBS. Even if the business is a domestic C corporation, it cannot be a cooperative, real estate investment trust, REMIC, regulated investment company, or presently or formerly DISC.
From August 9, 1993, till the issue, the business’s or its predecessor’s total gross assets must not exceed $50 million. If a business’s gross assets have surpassed $50 million following August 9, 1993, it cannot issue QSBS again, even if they are less than $50 million at the time of issuance. Stock issued before the threshold won’t be affected.
After the issue date, the corporation’s total gross assets shall not exceed $50 million. If a fundraising round brings the company beyond $50 million, subsequent shares will not be QSBS.
Cash plus other property’s adjusted tax basis make up a company’s aggregate gross assets. Because this criterion looks at a corporation’s tax base rather than its valuation, it may have large self-created intangible assets, be it goodwill, without exceeding the $50 million limit.
Shareholders commit valued property to a business for its shares, such as when a partnership becomes a C corporation. A property’s adjusted basis cannot be less than its fair market value (FMV) when transferred. This provision complicates compliance with the $50 million test since there are no legislative rules for calculating a corporation’s gross assets once the property is given. Contributed assets must also be valued.
Original issuance requirements
The current holder must have purchased QSBS at “original issuance”. Even though this test often solely pertains to shareholders, a few important factors are discussed below for corporate consideration –
- Stock must be purchased directly from the issuing company in return for cash, another kind of asset (not another share of stock), or as payment for services rendered to the company. As a result, a stakeholder who buys shares through a transfer from an individual shareholder will not be regarded as having acquired the stock at the initial issue.
- Stock is regarded as being purchased at the time of issue if it is obtained via the exercise of options, warrants, or convertible debt. But remember that the stock’s holding term doesn’t start until the conversion date.
How do you know if your stock is qualified?
If you bought shares from a US C-Corp business with gross assets valuing less than $50 million, your shares might be eligible for the exclusion. Let’s look at the conditions –
- The business’s assets must be used for active company operations at least 80% of the time rather than being employed for outside investments.
- The stock must have been held for at least five years. This time would start from the conversion date if you owned a note or an option that was subsequently converted into stock.
- You must have bought the shares from the issuing corporation in exchange for money, goods, or services (including intellectual property).
- Note that several service industries, such as those in healthcare, law, finance, and architecture, and industries reliant on natural resources, such as farming and mining, are not eligible for the exception.
Remember that shares of a corporation with gross assets beyond $50 million may still be eligible. Simply put, if your shares are issued before the business hits the $50 million mark.
Why multiply your QSBS?
Currently, you may benefit from the QSBS exclusion scheme and holding term of the original owner if you get eligible stock as a gift, inheritance, or distribution.
Here is an illustration of why this is significant. Assume you are a business owner with $40 million worth of qualifying stock. You set up three distinct irreversible non-grantor trusts for your three children, giving them $10 million in stock each while keeping $10 million for yourself.
Five years later, a cash sale of the business increases the value of your initial $40 million in shares to $80 million. You would be qualified for a $10 million exclusion if you hadn’t given any shares as gifts. Now, though, more people are qualified for the exclusion than just you since you gave your shares.
The combined federal tax exclusion for the three trusts, who are independent taxpayers, is $40 million, quadrupling your tax savings. Each of the three trusts is qualified for its own $10 million exclusion. Furthermore, you would transfer $60 million of your wealth via the gift using just $30 million of your lifetime gift tax exemptions.
Common QSBS pitfalls companies make
When preparing for the QSBS exclusion, some of the most frequent mistakes include the following –
- Not aware of it – Many owners of small businesses are either unaware of the exclusion or haven’t given much consideration as to what they should be doing to take full advantage of the QSBS opportunity. When it comes time to get ready for an IPO, discuss finance, or look for a buyer for the company, this may have a very detrimental effect. If you formed your business as an LLC and the QSBS asset criteria can be satisfied, you can consider speaking with a tax law professional to convert from an LLC to a C-Corp.
- Redemption risks – The company’s stock may become ineligible for QSBS if it is redeemed for more than 5% of its total worth within a year or from a connected party to the QSBS holder for two years. In tiny businesses, it is regrettably not uncommon for one of many early workers to decide to depart. Instead of waiting until later, the other workers will utilize corporate resources to buy that person out, accidentally disqualifying all of the firm’s equity.
- Gifting or selling QSBS unintentionally – Giving qualifying stock as a gift may be a very effective planning strategy, but you don’t want to do it accidentally. Giving QSBS qualifying stock to a charity may be a bad idea since the charity doesn’t get any extra tax advantages, and you lose out on a sizable tax advantage without increasing your charitable deduction.
- Not investing soon enough – The timing of your participation in a venture fund may have a significant influence on your ability to participate in earlier QSBS-qualifying portfolio company investments for limited partners and other strategic investors. Assess the potential tax advantages of investing in a fund’s QSBS-qualifying firms as you consider the timing of your investments.
- Delay in exercising stock options – Many start-up workers wrongly believe the 5-year rule starts when their options vest, regardless of their knowledge of the QSBS exception. As previously stated, the mandatory holding period does not truly start until the options are exercised. Concentrating stock holding may interfere with your financial goals and elevate investing risks.
- Missing the rollover opportunity – If you have held your stock for at least six months but not the full five years when you sell it, you could roll over your gain into the stock acquired from another QSBS-eligible C-Corp within 60 days to avoid paying taxes on the gain, keep your QSBS status, and benefit from the capital gains exclusion once the full five years have passed.
- Not keeping track of your stock – Further investment rounds require financial statements and other supporting documents. Detailed balance sheets and other records indicating the stock details from the start of a company’s existence through the closing date are vital. Hence an eye for up-to-date records of stock acquired and available should be ensured to promptly record and stored.
- Not choosing the right time for sales – Let’s explore the “what if” scenarios because you must retain your QSBS stock for at least five years to be able to deduct capital gains. You are forced to sell your shares before it is time, which results in a large taxable gain. You continue operating your business as a C Corp and forfeit the benefits of a pass-through. It’s not good. On the other hand, you may sell at a loss and miss years of advantages from operating as a pass-through. This is also not good.
- Double taxation of C corp – C corporations, sometimes known as “C corps” subject company owners to two levels of taxation if and when earnings are dispersed – a corporate-level tax and an owner-level tax. Pass-through businesses are often more favorable for small company owners due to this second layer of taxes. Pass-through company owners benefit from a single tax layer and a qualified business income deduction (QBID), which, with some restrictions, allows them to avoid paying income taxes on 20% of their business income, starting in 2018.
- Asset vs. stock sale – Either selling stock or assets often sell businesses. However, purchasers could favor asset sales. Why? If a buyer of company assets has the right to assign the purchase price to those assets, they will often also have the right to amortize or depreciate that cost over time. What does this entail, then? Company assets should command a greater price from a buyer than business stock does. You are generally better off keeping a pass-through if the price increase is more than the money you save via the Section 1202 gain exclusion.
Common mistakes investors make with QSBS
QSBS offers amazing tax benefits to investors that can help them save millions of capital gains. However, they often lose these benefits by making the following mistakes –
- Track the wrong numbers – After two or three equity rounds, or around Series B or Series C, most companies lose their QSBS designation. This is because the amount of total cash spent plus the gross asset worth of a firm often exceeds the $50 million mark soon after such investment. A lot of investors track wrong numbers because investment made via SAFE before the series B round depends on whether the SAFE is seen as (1) equity at the purchase or (2) a prepaid forward contract until the SAFE transforms into preferred stock will determine. Some tax experts contend that all SAFEs count as equity for tax purposes. However, they add a warning: “The IRS might claim that SAFEs should be considered for tax reasons as a prepaid forward contract rather than equity”. In any event, because this area of tax law is unclear, act with care and consult your tax advisors.
- Not keeping a good record – Your key to proving your claim for QSBS is supporting documentation like financial statements and other records. You may determine if a firm has more than $50 million in total gross assets by looking at detailed balance statements from the beginning of its existence up to the day your investment was closed. Additionally, equity papers will also be important. Surprisingly simple reporting requirements exist for QSBS benefits. No unique filing, optional form, or other notification is necessary. Most businesses won’t even acknowledge it after a departure. Instead, all that is legally necessary for the taxpayer to claim QSBS status is for them to declare the selling of QSBS on Tax Form 1040, Schedule D., and Form 8949, just like any other capital gain. And the IRS typically has three years to reopen an audit or ask you to make any necessary reports to the IRS and shareholders.
- Assume QSBS applies – Many VCs have preconceived notions about how QSBS works. Investing 10% or more of a firm’s assets or making investments in a portfolio company that isn’t engaged in an active trade or activity are just a few of the possible dangers in this complex tax regulation. Companies must comply with Section 1202’s active business criteria, which call for at least 80% of their assets to be employed actively in a qualifying trade or activity. Make sure investors are aware of which companies don’t fit the bill.
How to avoid QSBS pitfalls?
Now that you know the common pitfalls of qualified small business stock for companies and investors, it is important to avoid them to maximize your capital gain exclusion. Using a cap table to track QSBS can prove to work on your behalf in tracking and maintaining a proper record. It could help companies to track all the information about the issued options, including time. This will ensure that you or your employees do not delay exercising their options and miss the rollover opportunity in case the QSBS can’t be held for 5 years.
For investors, a cap table can become a good habit of record keeping. It will not only help maintain the right numbers and track the kind of investment made but also help them during the time of tax reporting.
Use software to keep track of your stock
Small businesses and entrepreneurs often start using Excel sheets for cap tables. However, with growing investments and the issuance of stock, it becomes increasingly complex. Excel may be a simple tool for producing documents used in a variety of ways, but using Excel templates requires a lot of time and work. It’s not always feasible to see errors made while altering Excel templates. The cap table software is thus strongly suggested since it helps to lower risks and mistakes. The flaws that are often present in Excel sheet layouts are eliminated with the help of Eqvista’s cap table software.
Choose Eqvista’s software to keep track of your QSBS!
If you’re looking for cap table management to help you maximize QSBS advantages, Eqvista is the ideal place to look. You may keep track of every share you own, including QSBS, using the cap table provided by Eqvista. Additionally, we guarantee that you never miss a chance to exercise! Try out our cap table software, and get in touch with us if you need assistance.