Taxes

The QSBS Exemption Tax Benefit (IRC Section 1202)

By  Opher Ganel

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Do You Know About This Epic Little $10 Million Tax Benefit?

As something of a personal finance enthusiast, I was absolutely gobsmacked (does anyone actually use that word?) by this one.

Imagine you get a multi-million-dollar windfall, and when it’s time to pay tax on it, Uncle Sam says, “Nah, never mind. I’m feeling generous today. You can keep it all!

Really?! That can happen?! Turns out it can!

The QSBS: A Little-Known Provision of the Internal Revenue Code (IRC Section 1202) that Can Save You Millions

First, a caveat.

Not everyone can benefit from 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 need to get this windfall under very specific circumstances.

The History of the QSBS Exemption and IRC Section 1202

Our story starts back in August of 1993, with President Bill Clinton signing into law the so-called Revenue Reconciliation Act (RRA). Back then (and I guess not just then), the country was dealing with high national deficits. After a highly contentious debate in Congress, the “ayes” had it and the bill went to Bill, who signed it.

The intention of the RRA, and IRC § 1202 as part of it, was to increase tax collections by (counter-intuitively) creating a significant tax break. Congress wanted to encourage job creation (more taxpayers paying more individual taxes) and long-term economic growth (generating more corporate tax revenues).

But how?” you may ask.

 The answer was to offer a Qualified Small Business Stock (QSBS) capital gains tax break in an attempt to incentivize long-term investments in small businesses and startups. After all, founding a startup, investing in one, and/or working for one, are all 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 Survived the Great Recession”:

As part of the RRA, Congress enacted IRC § 1202 as an incentive designed to promote long-term investments in small businesses and venture capital start-ups by providing a partial exclusion of gain on the sale of the QSBS after the 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 holding period required to obtain the tax break exists to allow the tax system to recoup as much tax revenue from the business activity as possible, since the tax system may lose revenue from the eventual partial tax-free sale of the corporation. Of course, it is also possible that the portion that is excluded from taxation will be reinvested, thereby stimulating the economy further…

In brief, IRC § 1202 allowed people who realized capital gain from selling shares of QSBS to pay the already low capital gains tax on just 50% of the gain, up to $10 million.

Fast forward 17 years and two presidents, and President Barack Obama signed into law a related bill, that increased the exemption from the 75% (that it had grown to over the intervening years) to 100%!

QSBS Rules – Part I: the Issuing Business Must Qualify

First, not all small businesses qualify. Section 1202 requires that the business:

  • Be incorporated as a US C-corporation (that rules out my S-corp).
  • Have gross assets of no more than $50 million at all times until immediately after issuing the stock.
  • Use at least 80% of its assets in its qualified trade or business.
  • Isn’t unqualified based on what it does (more details below).

Here’s a list of what the IRS says would disqualify a business (Source: IRS.gov):

  1. A business involving services performed in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services.
  2. A business whose principal asset is the reputation or skill of one or more employees.
  3. A banking, insurance, financing, leasing, investing, or similar business.
  4. A farming business (including the raising or harvesting of trees).
  5. A business involving the production of products for which percentage depletion can be claimed.
  6. A business of operating a hotel, motel, restaurant, or similar business.

Seeing this long list of potential disqualifications (e.g., items 2 and 3 put even more nails in the proverbial coffin of my business’s possible qualification), you might wonder what businesses might fit the bill. The main sectors that could qualify include technology, retail, wholesale, and manufacturing.

But wait! There’s more!

QSBS Rules – Part II: Limitations on the Share Owner and Shares

To qualify for the break:

  1. You have to be a person, a trust, or a pass-through entity (but not another corporation) subject to US taxation.
  2. You have to own stock of the QSB as opposed to options or other types of securities.
  3. You have to have obtained those shares in the original issuance, not the secondary market (i.e., you can’t buy them on a stock exchange).
  4. The shares must have been purchased with cash or property, or been awarded for services rendered. That last is often the case when startups make shares (or options that are later exercised) part of their employees’ compensation package.

Assuming you’ve jumped these two hurdles, you have to hold those shares 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 so within 60 days (a so-called 1045 QSBS rollover).

QSBS Rules – Part III: If You Qualify, It Gets Even Better (QSBS Tax Treatment)

The nice thing is that once you own QSB shares and manage to jump through all the regulatory hoops, your stock’s QSBS status will stick (until and unless Section 1202 is revoked or changed sufficiently, which may happen if Congress manages to pass a recently debated bill and get it signed into law). This even if the issuing business loses its QSB status for any new shares issued, the business is sold or merged into another company (and you may have exchanged the original QSB shares for shares of the buying company), and/or if you transfer, bequeath, or gift the shares.

Another nice little bit is that the exemption limit isn’t actually limited to $10 million. That’s just as low as it gets. If your cost basis is over $1 million, the QSBS exemption is worth 10 times your basis. Anything above that will be taxable at your long-term capital gains tax rates.

And a final juicy tidbit is that your QSBS exemption is additive – if you have QSBS from multiple businesses, you can exclude up to $10 million in capital gains (or 10× your basis, if that’s higher) from each business!

Expert Insights from Small Business Financial Advisors

“Many of the founders I interact with are unaware of the nuisances of Qualified Small Business Stock (“QSBS”) and the benefits and qualifications that come with it. Selling QSBS before five years, for example, might result in significant lost tax savings. Will it be advantageous to hold a deal off a bit longer or no? There are advanced strategies that should be considered, in concert with someone’s overall financial wealth plan and awareness is the first step. QSBS is just one piece of the massive puzzle and our role as Private Wealth Advisors is to bring all of the details in a concise manner, explain the different options with suggestions and partner with the founders to make decisions to better position their wealth and future.”- Max Sabert, CFP®, CIMA®, CEPA, Private Wealth Advisor, UBS Financial Services

The Bottom Line

As if all the above wasn’t confusing enough, there are other intricate details, such as the time you acquired the shares (if it was before or after September 27, 2010) that may affect the exemption percentage, the dreaded Alternative Minimum Tax (AMT), and the so-called Net Investment Income (NII) tax.

In addition, at the state level, some states/territories tax QSBS (e.g., Alabama, California, Mississippi, New Jersey, Pennsylvania, and Puerto Rico), so the QSBS must not be incorporated in any of those. Hawaii and Massachusetts add further twists and turns.

Given how convoluted a piece of tax law is involved, you’d be well advised to consult with a relevant expert like a small business financial advisor or Certified Exit Planning Advisor to make sure you get it right. It would be a shame if you ran afoul of a minor detail, blowing apart your attempt to take advantage either as a startup founder wanting to make the exemption available for your employees and venture capital investors or as the recipient of shares in the business.


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Disclaimer: This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.

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About the Author

Opher Ganel

My career has had many unpredictable twists and turns. A MSc in theoretical physics, PhD in experimental high-energy physics, postdoc in particle detector R&D, research position in experimental cosmic-ray physics (including a couple of visits to Antarctica), a brief stint at a small engineering services company supporting NASA, followed by starting my own small consulting practice supporting NASA projects and programs. Along the way, I started other micro businesses 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 finance goals.

Connect with me on my own site: OpherGanel.com and/or follow my Medium publication: medium.com/financial-strategy/.

Disclaimer: In order to make Wealthtender free for our readers, we earn money from advertisers including financial professionals and firms that pay to be featured on our platform. This creates a natural conflict of interest when we favor promotion of our clients over other professionals and firms not featured on Wealthtender. Learn how we operate with integrity to earn your trust.

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