There is a type of investment that you may have been hearing more about recently: the qualified small-business stock.
QSBS now offers 100% capital gains exclusion on taxes with no alternative minimum tax adjustment, while helping to generate investment in smaller businesses. Although QSBS has been around for nearly 30 years, several factors could prompt increased investor interest. The tax advantages of pass-through entities, such as S corporations and partnerships, have long made them a preferred entity for small businesses. But the federal tax overhaul of 2017 lowered the tax rate of C corporations to 21%. Unlike S corporations, some C corporations can issue tax-advantaged stock, which could make them a more attractive business structure.
To take advantage of the QSBS exclusion, both businesses and investors need to be aware of how it works, its potential limitations and the planning opportunities available.
What is the qualified small-business stock gain exclusion?
Under Internal Revenue Code Section 1202, under the Revenue Reconciliation Act of 1993, a domestic C corporation can issue QSBS if certain conditions are met. Qualifying investors can exclude all or a portion of their gain from their investment in QSBS if the stock is held for at least five years.
The QSBS exclusion is designed to encourage investment in small businesses, so the C corporation issuing the stock must meet the definition of a qualified small business. Its gross assets must not exceed $50 million between Aug. 9, 1993 – the effective date of the Revenue Reconciliation Act of 1993 – and the issuance of the stock. Immediately after the date of issuance, the aggregate gross assets of the corporation – including the consideration received for the issuance of the stock – must not exceed $50 million. Once a C corporation has gross assets exceeding $50 million, it is permanently prohibited from issuing additional stock that qualifies as QSBS.
C corporations must also have at least 80% of assets used in a qualifying trade or business. A number of business types are excluded from the benefit, including:
• Trades or businesses involving professional services in which the service relies on the skill of its employees, including health, law, engineering, accounting, consulting, financial services.
• Banking, insurance, financing or investing.
• Most farming businesses.
• Oil and gas extraction.
• Hospitality, including hotel, motel, restaurants or similar businesses.
The C corporation must remain a C corporation for substantially all of the stockholder’s holding period.
Which types of investors benefit from QSBS?
Investors also must meet certain requirements in order to take advantage of the capital gains exclusion. The investor cannot be structured as a C corporation. It also must acquire the QSBS directly from the qualified small business. The original issuance requirement includes:
• Exercising stock options or warrants, or through a conversion of convertible debt.
• Stock options acquired as a gift or estate benefit.
• Stock options acquired as a distribution from a partnership under certain parameters.
Investors that do not qualify for the QSBS exclusion may still have some planning options available to them to limit the capital gains tax consequences on their stock. Internal Revenue Code Section 1045 provides rollover opportunities for investors to defer the gain on qualified small-business stock that is held for at least six months.
Joanna Powell is a managing director in the New England office of CBIZ & MHM, an accounting and tax provider with offices nationwide, including Providence and Boston.