TAX ADVANTAGES OF OWNING (AND SELLING) “QUALIFIED SMALL BUSINESS STOCK”—THE QSBS EXCLUSION

Croke Fairchild Duarte & Beres Client Insight

By Andrew Szymulanski *

The following discussion is intended to provide a brief overview of Internal Revenue Code Section 1202. In short, Section 1202 exempts from tax gain realized on the sale of certain stock. More specifically, Section 1202 provides that taxable income does not include gain from the sale or exchange of “qualified small business stock” held for more than five years (“QSBS Exclusion”).

Notably, the QSBS Exclusion affords business owners selling stock in closely held corporations one of the few opportunities under the Code, not only to defer, but to completely avoid the taxation of income, making it an extremely powerful tax planning tool.

Gain excludable from income under Section 1202 is limited to $10,000,000 or, generally, a ten-times multiple of the taxpayer’s investment to acquire the QSBS, whichever is greater. Stock in a corporation is not treated as QSBS unless the corporation meets certain active business requirements during substantially all of the taxpayer’s holding period for such stock and the corporation is a “C” corporation. (Section 1202 does not exempt gain on the sale of stock in an “S” corporation). A qualified trade or business means any trade or business other than a trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees (“Disqualified Business”).

Although Section 1202 permits the Internal Revenue Service to require specific tax reporting, the IRS has not mandated any such reports. Under present law, a corporation simply must be in existence and must meet the relevant criteria without making any mandated filings with the IRS. However, a number of technical requirements must be satisfied in order to apply the QSBS Exclusion:

?????????????? i.????????????????? The taxpayer taking advantage of the QSBS Exclusion must not itself be a “C” corporation. Individuals and trusts (as well as “S” corporations and partnerships which pass their gains through to them) are eligible for the QSBS Exclusion;

???????????? ii.????????????????? The QSBS must have been held for more than 5 years at the time of sale;

??????????? iii.????????????????? The QSBS was?issued by the corporation to the taxpayer (as opposed to being?purchased from another shareholder);

??????????? iv.????????????????? The QSBS was issued during a period of time when the corporation did not redeem stock from the taxpayer or other shareholders (there are certain exceptions to this rule);

????????????? v.????????????????? The QSBS was issued by an entity classified as a “C” corporation for U.S. federal income tax purposes (an LLC?could issue QSBS if the LLC elected to be taxed as a C corporation);

??????????? vi.????????????????? The QSBS was issued in exchange for money, property (other than stock), or services (QSBS can be issued in exchange for stock if the stock exchanged is itself QSBS);

????????? vii.????????????????? At the time of issuing the QSBS, the corporation had $50 million or less in gross assets (where $50 million is measured by reference to the assets’ fair market value or their tax basis, depending on the circumstances);

???????? viii.????????????????? The issuing corporation uses (a) at least 80 percent of its assets in an active trade or business and invests (b) 10 percent or less of its assets in portfolio stock, securities, or nonbusiness real estate;

??????????? ix.????????????????? The issuing corporation’s trade or business is not a Disqualified Business as discussed above; and

????????????? x.????????????????? The issuing corporation met the active trade or business requirements and was taxed as a “C” corporation during “substantially all” of the seller’s holding period of the QSBS.?

Finally, investors in a company that purports to qualify to issue QSBS will frequently ask for representations on some of the above criteria and covenants that the company will seek to maintain qualification, for example, by ensuring that at least 80 percent of the assets are deployed in an active trade or business.

* Andrew Szymulanski is a partner in the Chicago office of Croke Fairchild Duarte & Beres (“Croke Fairchild”) where he focuses his practice on tax matters. Andrew may be reached at 1.224.216.6620 and [email protected] .

Founded in 2019, Croke Fairchild is a growing, corporate, business, securities, litigation, real estate, and tax law firm headquartered in Chicago, Illinois. The firm partners with clients on delivering results-driven, cost-effective counsel, in the service of clients’ long-term success. www.crokefairchild.com

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