You know this epic little $10 million tax break?
As some sort of personal finance enthusiast, I was absolutely stunned (does anyone actually use that word?) by this one.
Imagine getting a multi-million dollar windfall, and when it comes time to pay taxes on it, Uncle Sam says, “No, never mind. I feel generous today. You can keep it all!”
Real?! That can happen?! It turns out it can!
The QSBS: A Little-Known Provision of the Internal Revenue Code (IRC Section 1202) That Could Save You Millions
First a warning.
Not everyone can take advantage of this, and I’m not just referring to the fact that not too many of us get a multi-million dollar windfall very often…
You have to get this windfall under very specific circumstances.
The History of the QSBS Exemption and IRC Section 1202
Our story begins in August 1993, when President Bill Clinton signed the so-called Revenue Reconciliation Act (RRA). At the time (and I don’t think only then) the country was dealing with high national deficits. After a highly controversial debate in Congress, the “ayes” had it and the bill went to Bill, who signed it.
The intent of the RRA, and IRC § 1202 as part of it, was to increase tax collections by (counter-intuitively) creating a significant tax advantage. Congress wanted to encourage job creation (more taxpayers paying more individual taxes) and long-term economic growth (generating more corporate tax revenue).
“But how?” you may ask.
The answer was to offer a Qualified Small Business Stock (QSBS) capital gains tax benefit in an effort to boost long-term investment in small businesses and startups. After all, setting up a startup, investing in it and/or working for it are intrinsically risky propositions.
As Beckett G. Cantley wrote in the Fordham Journal of Corporate & Financial Law (Volume 17 Issue 4 Article 6, 2012), in a piece titled “The New Section 1202 Tax-Free Business Sale: Congress Rewards Small Businesses That Have Experienced the Great Recession survived”:
“As part of the RRA, Congress enacted IRC § 1202 as an incentive to promote long-term investment in small businesses and venture capital startups by partially excluding profits from the sale of the QSBS after its fifth year of operation. † The rationale of the tax break is to encourage entrepreneurs and investors to start and operate businesses that would generate economic activity and employment. It is likely that the five-year period required to obtain the tax benefit exists to allow the tax system to recover as much tax revenue from the business as possible, as the tax system may lose revenue from the final partial tax-free sale of the corporation. . It is of course also possible that the part that is excluded from tax will be reinvested, further stimulating the economy…”
Basically, IRC 1202 allowed people who realized capital gains by selling shares of QSBS to pay the already low capital gains tax on only 50% of the profit, up to $10 million.
Fast forward 17 years and two presidents, and President Barack Obama signed a related bill, increasing the exemption from the 75% (which it had grown to in the intervening years) to 100%!
QSBS Rules – Part I: The issuing company must be eligible
First, not all small businesses qualify. Section 1202 requires that the company:
Being listed as a US C-corporation (that excludes my S-corp). Have gross assets of not more than $50 million at all times until immediately after issuance of the shares. Uses at least 80% of its assets in its qualified trade or business. Is not unqualified based on what it does (more details below).
Here’s a list of what the IRS says would disqualify a company (Source: IRS.gov):
A company providing health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or real estate services. A business whose principal asset is the reputation or proficiency of one or more banking, insurance, financing, leasing, investment or similar business. An agricultural business (including growing or harvesting trees). hotel, motel, restaurant or similar business.
Seeing this long list of potential disqualifications (e.g. items 2 and 3 drive even more nails into the proverbial coffin of my company’s potential disqualification), you may be wondering which companies qualify. The main sectors that can qualify include technology, retail, wholesale and manufacturing.
But wait! There is more!
QSBS Rules – Part II: Restrictions on Shareholder and Shares
To qualify for the break:
You must be an individual, trust, or pass-through entity (but not another corporation) subject to U.S. taxation. You must own shares of the QSB as opposed to options or other types of securities. those shares are in the original issue, not on the secondary market (ie you cannot buy them on a stock exchange). Shares must have been purchased with cash or real estate, or awarded for services rendered. The latter is often the case when startups make shares (or options that are exercised later) part of their employees’ compensation package.
Assuming you’ve cleared these two hurdles, you’ll need to hold those stocks for at least 5 years to qualify. The nice thing, if you have to sell before that 5-year period ends, is that you can reinvest the proceeds in another company’s QSBS, as long as you do that within 60 days (called a 1045 QSBS rollover).
QSBS Rules – Part III: Qualifying Makes It Even Better (QSBS Tax Treatment)
The cool thing is that once you own QSB stock and manage to jump through all the regulatory hoops, your stock’s QSBS status will remain (until and unless Section 1202 is sufficiently repealed or amended, which could happen if Congress moves in. succeeds in passing a recently discussed bill and has it signed into law). Even if the issuing company loses QSB status for new shares issued, the company is sold or merged with another company (and you may have exchanged the original QSB shares for shares of the buying company), and/or if you transfer, leave or donate the shares.
Another nice touch is that the exemption limit isn’t really capped at $10 million. That’s as low as can be. If your cost base is over $1 million, the QSBS exemption is worth 10 times your base. Anything above that is taxable against your long-term capital gains tax rate.
And one last juicy tidbit is that your QSBS exemption is additive – if you have QSBS from multiple companies, you can exclude up to $10 million in capital gains (or 10× your base, whichever is higher) from each company!
It comes down to
As if all of the above wasn’t confusing enough, there are other intricate details like when you acquired the stock (if it was before or after September 27, 2010) that could affect the exemption rate, the dreaded alternative minimum tax ( AMT), and the so-called net income tax (NII).
In addition, some state-level states/territories tax QSBS (e.g., Alabama, California, Mississippi, New Jersey, Pennsylvania, and Puerto Rico), so the QSBS should not be included in any of these. Hawaii and Massachusetts add even more twists.
Given how complicated a piece of tax law is, you would do well to consult with a relevant expert, such as a small business financial advisor or certified exit planning advisor, to make sure you’re getting it right. It would be a shame if you came across one small detail that ruined your attempt to profit, either as a startup founder seeking to make the exemption available to your employees and venture capital investors, or as a recipient of shares in the company.
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Disclaimer: This article is for informational purposes only and should not be construed as financial advice. You should consult a financial professional before making any major financial decisions.
About the author
Opher Ganel
My career has taken many unpredictable turns. An MSc in theoretical physics, PhD in experimental high energy physics, postdoc in particle detector R&D, research position in experimental cosmic radiation physics (including a few visits to Antarctica), a short stint at a small engineering firm supporting NASA, followed by starting my own small consulting practice supporting NASA projects and programs. Meanwhile, I started other micro-enterprises and helped my wife start and grow her own marriage and family therapy practice. Now I use all these experiences to also offer financial strategy services to help independent professionals achieve their personal and business financial goals.
Connect with me on my own site: OpherGanel.com and/or follow my Medium publication: medium.com/financial-strategy/.
This post The QSBS Exemption Tax Benefit (IRC Section 1202)
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