Understand Qualified Small Business Stock

One generous but fluid provision in the tax law that has survived through decades of Democratic and Republican administrations surrounds Qualified Small Business Stock (QSBS). The purpose of QSBS’ special tax treatment is to provide incentives to invest in new businesses that enhance the nation’s competitiveness and accelerate job creation. For company founders, early employees and early-stage investors, QSBS can be a powerful way to save a bundle in capital gain taxes.

What is QSBS?

The QSBS statute was drafted to allow investors to exclude capital gains on qualified businesses, especially those engaged in research and development of new technologies. Once an investor has owned the shares for five years, they are potentially able to exclude a large portion of capital gain, up to the greater of $10 million or 10x their original investment.

How much you can exclude?

When the law was originally written in 1993, the prevailing long-term capital gain rate was 28%, and half of the gain on QSBS shares could be excluded. This resulted in a reduced net tax rate of 14%. With the capital gain rate reduced to 15% in 2003, the QSBS effective rate provided little benefit. Congress responded by increasing the QSBS exclusion to 75% in 2009 making the effective tax rate 7%, an advantage of 8% over regular rates. Since 2010, the exclusion increased to 100%.

Why this trip down memory lane for the changes in the QSBS exclusion percentage? Because the exclusion percentage for a specific lot of QSBS shares has been based on the rule in effect when the stock was issued. Democrats are now proposing to reduce the exclusion rate back to 50% for anyone with adjusted gross income of $400,000, to pay for new climate and social safety net programs. Note that a few states, including California, do not allow this federal tax break.

What does “qualified” mean?

Given the size of the potential tax break, understandably there are many constraints on what qualifies for QSBS gain exclusion after the five-year holding period:

1. The shares must be in a U.S. C Corp business
2. The investor must acquire shares directly from the company at original issue
3. The company balance sheet after the share acquisition must be less than $50 million

Finally, the business must operate as a qualified business activity. This last restriction is the most subjective with some debate about the companies that qualify. The IRS defines (Publication 550, page 63) any trade or business as “qualified” other than those specifically excluded — most professional services, finance, farming, resource extraction and hospitality businesses do not qualify.

There are also a myriad of eligibility rules pertaining to the holder of the shares. Given the complexity of the tax code around the qualification, it’s important you have a tax professional well-versed in the rules on your team. Also, be in contact with a knowledgeable person at the company where you hold the shares, such as the corporate counsel or chief financial officer.

Planning tips

From the wealth planning perspective, there are several opportunities and risks when it comes to managing QSBS in your portfolio. Here are a few important things to keep in mind.

Diversify your QSBS

The problem with high-gain, concentrated assets in your portfolio is that the concentration may be too risky for your specific financial situation, but there’s potentially a high tax cost to selling. If your financial independence is banking on these assets, you have a few options:

• Option 1 — Bite the bullet, pay the big tax bill, and do the diversification you know you should do. But you may feel dismayed that a meaningful chunk of the profits is gone.
• Option 2 — Choose to not pay the big tax bill. Instead, leave your financial independence or future retirement date riding on a potentially volatile asset and suffer the restless nights that may accompany this decision.
• Option 3 — Consider less common techniques, such as participating in an exchange fund which provides diversification but with trade-offs of illiquidity and added fees.

If you are fortunate to have mature QSBS shares with large gains, these then become an obvious candidate to sell and diversify. If current law stands, you keep all gains up to $10 million or 10x your cost basis, which can then go toward your safer, diversified nest egg. Working with a financial advisor can help you understand if that will help you reach your financial goals or map out the additional steps needed to get you there.

Rollover your QSBS

The QSBS exclusion applies per issuer, per taxpayer. This opens an opportunity if you have QSBS gains in excess of the limit. One option is to reinvest the portion of your QSBS above the capital gain limits into another company’s QSBS within 60 days, tax free. Obviously 60 days is not a lot of time, so due diligence will be needed in advance of selling your original QSBS stock.

But if you can get this done, you can maximize your QSBS exclusion on your original investment and get another exclusion on the QSBS from the new company issuer. Also consider the rollover option if you don’t wish to continue owning shares in the company but also don’t want to recognize the capital gain (e.g., if the five-year holding period has not been met).

Exercise your QSBS options

Most early employees of a startup get their equity compensation in the form of options. Remember that one of the qualifications to get the QSBS exclusion is that the assets of the corporation must be under $50 million at the time of your purchase. With options, the purchase is not measured from when you are granted the options, but when you exercise the option to buy shares. Part of your calculus on whether to exercise needs to include retaining QSBS exclusion eligibility. If you wait to exercise and your company’s assets exceed $50 million, then you will lose out on gaining QSBS status.

Of course, this must be weighed with other considerations when exercising options. These include your views on the future of your company, potential alternative minimum tax liability and your personal circumstances. There are many factors to consider and having a financial advisor to help you identify and evaluate them will be very valuable.

Estate plan with QSBS

Recall that the QSBS exclusion limits apply per issuer, per taxpayer. This may open the door for advanced planning techniques. One such example is to gift the shares, either outright to children or through irrevocable trusts. This has the potential to multiply the QSBS benefit — by applying the capital gain exclusion to you and also to the other taxpayer, whether it be a person or a non-grantor trust. This planning must be done with an estate attorney professional experienced in QSBS rules. Creating trusts for the express purpose of tax avoidance can be examined and disallowed by the IRS.

Keep good records and work with a smart team

An overhaul of the QSBS exclusion rate is back on the table. The Biden administration opened a debate on the equity of capital gains being taxed at lower rates than earned income. Whether the current 100% exclusion rate stays or is reduced, QSBS remains a generous tax provision seen to be a worthy tradeoff for the incentives it creates for new business formation and job creation.

If you hold QSBS stock, gather a team of knowledgeable professionals to fully comply with the rules and maximize the benefits based on your personal circumstances and the changing tax law landscape.