The ability to exclude capital gains from the sale of qualified small business stock (QSBS) is one of the strongest and most exciting tax opportunities for business owners. Individuals are allowed to take away $10 million or 10 times their initial investment in their company, with the possibility of excluding up to $500 million in profits.
Most business owners are surprised to see how much tax they can save with this provision. They think it’s too good to be true. it’s not.
The purpose of the exception in Section 1202, when it was enacted in 1993, was to encourage investment in capital in small businesses, which is exactly what it did. It started as a 50% exclusion, then gradually increased over time to 75%, and then to 100% for QSBS acquired after 27 September 2010.
Currently, Congress is considering eliminating the 75% and 100% exclusion rates for taxpayers who earn at least $400,000 annually. This is one of the proposals in the recent iteration of the much-discussed reconciliation bill.
The majority of taxpayers who benefit from this provision work in the technology industry, mainly because of the potential for a rapid and massive rise in stock prices in this sector, but it applies equally forcefully to manufacturing and other industries.
There are also many planning strategies that can be used to multiply and expand the $10 million bases and 10 times the above bases. These strategies are sometimes referred to as stacking and bagging, and should not be overlooked.
This article summarizes the requirements to qualify for the exclusion of gains under Section 1202 and focuses on recent developments from the IRS and from Congress.
There are requirements that apply to the company (in another meaning. , a QSBS issuer), and there are requirements that apply to individual shareholders (in another meaning. , taxpayers excluding profit from the sale of QSBS). Let’s start with the source requirements.
The corporation must be a domestic C corporation when the QSBS is issued and when the taxpayer/shareholder sells the QSBS. This means that a corporation cannot be a non-US corporation, an S corporation (a pass-through entity similar to a partnership), nor can it be a mutual fund, real estate investment trust (REIT), or other designated entities.
The company must have been engaged in a Qualifying Trade or Business (QTB) during “everything” (likely somewhere between 70% and 90%) of the taxpayer’s holding period of inventory. QTB is any trade or business other than some excluded business. The excluded businesses include:
- Any trade or business that involves the performance of services in the areas of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business in which the principal origin of that trade is or Business is the reputation or skill of 1 or more of its employees;
- any banking, insurance, financing, leasing, investment or similar business;
- any agricultural work (including tree growing or harvesting work);
- any business involving the production or extraction of products of a nature in connection with the deduction permitted under Section 613 or 613a; And
- Any business related to the operation of a hotel, motel, restaurant or similar business.
The company must also use at least 80% of the value of its assets in active QTB management. This requirement is generally not a problem for companies unless they have excess working capital or are getting “bad” business like an insurance or brokerage company. In this case, the company will need to keep track of its “good” and “bad” business values to ensure that at least 80% of its assets are used in the “good” business. This is not always easy to do.
The total assets of the Company at all times prior to the relevant QSBS issue, and “immediately” following the issue of QSBS, shall not exceed US$50 million. There are a lot of nuances in this account.
Finally, the company must not have participated in certain redemption transactions from its shareholders, must not hold more than 10% of the value of its assets in portfolio stock (generally 50% or less of owned subsidiaries), and must not own more than 10% of the value of its assets Its assets are in real estate not used in its business.
On the shareholder side, the requirements are less onerous. First, the shareholder must be an individual, trust, estate, partnership, S corporation, mutual fund or mutual trust. Second, the shareholder must have obtained the shares from the company after August 10, 1993 in an “original issue”, i.e. from the company itself in exchange for money, property (other than shares) or services, but not from another shareholder in a cross-purchase. There are exceptions that allow reorganization, gifts, and probate shares, but let’s put them aside for now.
The last requirement is that the shareholder must hold the stock continuously for more than 5 years without engaging in certain transactions that hedge or reduce the risk of owning the shares. Hedging requirements are often not a problem because these companies are usually not publicly traded.
Assuming that the issuer and shareholder requirements are met, the shareholder qualifies for an exemption from QSBS sale gains. The specific percentage exclusion will depend on the date the shareholder acquired the stock.
Regarding care, companies generally seek guidance from a qualified tax advisor early in the process to ensure that their owners can qualify for exclusion. This is due to the volume of exclusion and because of the need to track certain requirements over time. It’s also important to potential investors – they’ll want to know if their projected earnings will qualify for QSBS.
IRS إرشادات Guidelines
From 1998 to 2016, the IRS issued seven special letter rulings that address how QSBS rules apply to certain reorganization transactions. The most important point of these provisions is that a limited liability company (LLC) can qualify under Section 1202 if it checks the box to be treated as a corporation for tax purposes. This is useful because many businesses start out as LLCs (taxed as partnerships) before they convert to corporation status.
The IRS made rulings in 2014 and 2017 that address what it means to perform services in a “health business,” because health business is excluded from the meaning of QTB. It then issued three more rulings in 2021 – two dealing with health business, one addressing the meaning of mediation business, and one excluding. The latest healthcare provisions were issued on November 5, 2021.
All five provisions of QTB are taxpayer-friendly because the IRS took a narrow view of the exceptions and found, explicitly in one case, that being “in close proximity” to an excluded company was not enough to exclude a company from a QSBS transaction.
The IRS interprets the health business as one where medical providers meet patients, make diagnoses and predictions, and otherwise provide medical care to patients. It does not include companies that work with clients to develop and commercialize experimental drugs because they spread manufacturing assets and intellectual property into the broader pharmaceutical industry. It also does not include companies that provide lab reports to health care professionals, companies that make medical devices to patients, and companies that develop programs to help medical providers deliver medical treatment to patients.
Similarly, the IRS has limited the scope of brokerage exclusion by allowing QSBS to treat an insurance broker that provides management services to its clients. Upon finding that an insurance broker did more than just a traditional “broker,” the IRS referred to the dictionary definition of a broker as “a middleman such as an agent who arranges marriages or a person who negotiates contracts for the purchase and sale of real estate, goods, or securities.” This narrows the scope of the exclusion Mediator to a large extent.
Finally, the IRS ruled in all five QTB rulings that taxpayers were not within the exclusion for companies whose primary assets are the reputation or skill of one or more of their employees. This category, although not defined for the purposes of Section 1202, has been defined too narrowly in an unrelated context. In this context, it was limited to companies that earn income from endorsements, appearances, and fees for licensing a person’s image, voice, and signature. etc.. We hope that the IRS will adhere to this approach in future QSBS guidance.
Section 1202 was previously thought to be exempt from tax reform because it was intended to encourage capital investments in small businesses. Congress surprised everyone in September 2021 when the House Ways and Means Committee proposed tapering some of the benefits of QSBS treatment. Specifically, the proposal would have eliminated the 75% and 100% exclusion rates for taxpayers earning at least $400,000 annually, although the 50% exclusion would have applied to those taxpayers. But since the proposal would have included the gains from the sale of QSBS in calculating the minimum $400,000, it would apply to nearly every taxpayer selling QSBS. For credits and real estate, the proposal could have been applied regardless of the income threshold.
The proposal would also have been retroactive to sales after September 13, 2021, the date of the House proposal, but it would have been subject to an exemption for certain binding commitments made prior to that date. The Joint Tax Committee estimated that the QSBS proposal would raise $5.718 billion over 10 years.
Taxpayers were delighted when the White House in late October released a legislative framework that rescinded the QSBS proposal, but joy evaporated when the House W&M Committee brought it back to life in its revised legislative proposal on November 3, 2021 (Building Back Better). Read here for a summary of the legislative drama related to the BBB bill.) The new QSBS proposal is identical to the previous one – it even includes a retroactive provision.
The QSBS transaction is one of the few tax shelters that still exists today. For a taxpayer who excludes $10 million in capital gains at the 100% exclusion ratio, the tax savings could get closer to $3 million, assuming the seller’s domicile status complies with Section 1202. Not all of them do. New York does, but California and New Jersey do not.
If you think you qualify for QSBS treatment, or your company qualifies, reach out to your trusted tax advisor sooner rather than later because companies can float in and out of eligibility. The last thing you want to hear is that you would have qualified last year but no longer qualify this year.