Qualified Small Business (QSB) Stock Gain Exclusion: Who Can Take Advantage and How to Do It

Originally, selling stocks identified as having Qualified Small Business status was viewed as offering marginal benefit. But the last several years have seen incremental changes to how gains from the sales of these stocks have been treated. As of the most recent shift, which created a 100% exclusion with certain limitations, these stocks now offer significant opportunities for those who invest in startups and other small businesses.

The sale of Qualified Small Business (QSB) stock held for more than five years is addressed under Section 1202. It excludes gains from sales, but only under highly specific criteria and limitations. Tracking the exclusion’s history, stockholders were originally limited to excluding 50% of their gains from the sale of QSB stocks. That number was increased to 75% for shares acquired after February 17, 2009 and before September 28, 2010. Even then, the exclusion was viewed with little enthusiasm, as the gains not excluded were taxed at rates that were much higher than capital gains rates. All that changed when the exclusion was increased again to 100% for shares acquired after September 27, 2010.

There are important limitations to these exclusions: Most notably, for each taxable year, sellers are only permitted to exclude the greater of 10 times the aggregate adjusted bases of the QSB stock or $10 million dollars. Still, even with these limitations, the 100% exclusion has created a virtual tax-exempt gain that has inspired renewed interest in putting money into small businesses and startups. It has provided opportunities for pass-through entities like partnerships to buy and sell QSB stock at the ultimate investor level offered to noncorporate shareholders like trusts, estates and individuals, and this means that their total gain exclusion goes beyond the standard limitations. This means that each partner in a 10-partner group in which each owns 10% of the partnership’s QSB stock with $0 basis for $100 million can exclude their own share of the gain: the total qualifies because it is broken down to the ultimate investor view. Where this is a relatively simple calculation, for others the requirements of section 1202 are likely to create far greater barriers.

Understanding the requirements and considerations involving a QSB

Section 1202 contains many rules for being classified as a QSB, and though this article cannot cover all of them, it will point out important elements that businesses or investors thinking about their own qualifications should consider. Its most elemental criterion is that the business be a domestic C corporation whose aggregate gross assets have never exceeded $50 million through the time that the stock for which the gain exclusion is being sought was issued. Other requirements include:

• Gross asset test
Not only is there a requirement that the domestic C corporation not have had aggregate gross assets exceeding $50 million at any point between August 10, 1993 and the time that the stock seeking the QSB exemption was issued, but that limitation holds true for the time period immediately after the stock is issued as well. This is not based on fair market value – instead, gross assets are calculated based on the tax basis of the company’s assets. Still, fair market value is used to assess circumstances involving assets other than cash or when an existing business incorporated into the small business. It’s also important to understand that if a business is a member of parent-subsidiary controlled group, all corporations are treated as a single unit when calculating total gross assets.

• Original issuance requirement
In order to qualify for the exemption, the QSB stock shareholder must have first acquired it as an original owner, purchasing it for cash, by providing property, or providing services and obtaining it directly from either the corporation or its underwriter as a qualified shareholder. Buying the stock from another shareholder will not meet the original issuance requirement, and therefore will not qualify the holder of stock for the QSB stock gains exemption, though there are ways to get around this requirement. For example, investors could acquire a target business for the specific purpose of creating a new C corporation, and that would meet Section 1202’s criteria. Similarly, some tax-free incorporations or reorganizations that involve the exchange of QSB stock for stock of another organization may be eligible for exclusion of gains at a later point when the stock is sold.

For those who acquire QSB stock as a gift or by having inherited it, the original issuance requirement will not prevent the realization of the exemption benefit and the same is true of distributions to a noncorporate partner by a partnership as long as the noncorporate partner held its partnership interest when the partnership first acquired the QSB stock. This is a complex issue and many situations – including acquiring the stock as the satisfaction of debt for equity, through cashless warrant exercises, or through convertible debt conversions – should be addressed with our office.

• Active business requirement
The issuing corporation is required to be using at least 80% of its assets to operate one or more qualified trades or businesses (QTOB). This is gauged by value, and if more than half of a subsidiary corporation’s stock is owned by the corporation, then that ratable share must be included in the determination of the assets’ value and the percentage of assets being used for business operations.

The rules state that certain fields do not qualify as a QTOB, though whether a business falls into these categories or not may be open to interpretation and can introduce a significant amount of confusion. The fields listed as not qualifying include those involved in law, health, brokerage services, accounting, engineering, financial services, actuarial science, architecture, performing arts, consulting, or athletics.

Additional limitations based on issuer

Even once a shareholder meets the specifications that qualify them for the Section 1202 exclusions, there is an additional limitation based on the issuer of the QSB stock. That limitation is whichever of the following two elements is larger:

• Ten times the aggregate adjusted bases of the QB stock sold by the taxpayer during the taxable year
• $10 million, less the aggregate amount of eligible gain attributed to disposition of stocks issued by the same corporation that the taxpayer realized in a previous taxable year

As previously indicated, the excludible gain that is eligible must have been on sale or exchange of QSB stock owned for more than five years during the taxable year. This is applied at the shareholder level for each investor when the stock is held by a pass-through entity, and this is applied to each investor when calculating the per-issuer limitation. This effectively allows investors in partnerships, whether they are trusts, estates or individuals, to claim a gain exclusion that – when combined – is actually larger than the stated $10 million or 10 times the basis cap limitation. The gain exclusion amount can also be increased by gifting some of the stock in question to family members before the sale.

Summing Things Up

There are a lot of benefits available for those who can take advantage of the Section 1202 gain exclusion on the sale of QSB stock, but the requirements and eligibility criteria are intimidating and complicated. To protect your own interests and make sure that you understand how it applies to you, we urge you to speak with our office before claiming the exclusion for yourself.