Qualified Small Business Stock – Overview and Useful Strategies

Founders, entrepreneurs, venture capitalists and other investors (all of which are collectively referred to herein as “investors”) should be familiar with Internal Revenue Code Section 1202,^[1] a valuable provision that potentially allows for a significant amount of tax savings for investors selling qualified small business stock (“QSBS”). Section 1202 provides for, at least, a $10 million federal income tax gain exclusion in connection with an individual stockholder’s^[2] sale of QSBS held for more than five years, subject to a per-issuer limitation.

Section 1202 includes numerous company-level, and shareholder-level requirements that must be met.^[3] For example, the stock must be issued by a domestic C corporation for cash, property or services, and held by the stockholder (to whom the stock was originally issued) for more than five years. Additionally, the issuing corporation must be a “qualified small business.” This means it may not have had aggregate gross assets in excess of $50 million at any time prior to, or immediately after the issuance of the stock. Throughout the selling shareholder’s five-year holding period, the company must also use at least 80% of its assets in a “qualified trade or business.”^[4]

Assuming an investor does own, and plans to dispose of, valid QSBS after the required five-year holding period, the investor may generally exclude from income the greater of $10 million, or ten (10) times their aggregate adjusted basis in the stock sold. In either case, Section 1202 offers investors an incredibly valuable opportunity – which may be further increased by carefully employing various strategies. Strategies include: (i) dividing one’s QSBS ownership among multiple taxpayers; and (ii) incorporating an existing business that is operated by/through an entity taxed as a partnership.

In regards to dividing one’s QSBS ownership, recall that Section 1202’s exclusion is per-taxpayer.  Accordingly, an investor who owns QSBS may opt to divide their QSBS among multiple taxpayers, thereby increasing the number of exclusions available (colloquially referred to as “stacking”). Commonly, this is accomplished by an individual gifting QSBS to non-grantor trusts, structured to ensure each qualifies as a separate taxpayer for purposes of the per-issuer limitation.  Clients often use this strategy to compliment their estate and wealth planning. There are potential risks, though. For example, if the gifted stock has appreciated enough in value, the gift may be taxable.^[5] Accordingly, a cost-benefit analysis is always advisable.

The second strategy, incorporating a partnership, generally can be used to increase a partner-owner’s basis in their QSBS stock. Sometimes, for tax and non-tax reasons, business owners choose to operate their business as a limited partnership or limited liability company that is taxed as a partnership. If so, the owner could wait until the company’s assets have appreciated in value (i.e., > $1 million), and then convert the existing entity into a corporation pursuant to a state-law conversion statute.^[6] In this scenario, under the applicable tax rules, the business owner’s stock received upon incorporation generally would have basis equal to the fair market value of the company’s assets immediately before incorporation. Care must be taken, however, to ensure that at time of incorporation the existing company meets the “gross asset test” discussed earlier.

While this high-level summary may seem simple enough, as is often the case with tax planning, numerous traps exist for the unwary. Accordingly, due to the intricacies of Section 1202, investors should discuss with legal counsel and other trusted advisors whether it is possible and/or feasible for the business to be a qualified small business, and if so, the proper ways to maximize the value of their QSBS.

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[1] All references are to the Internal Revenue Code of 1986, as amended (the “Code”).  References herein to “Section” are to sections of the Code.

[2] The exclusion is available to other types of taxpayers, as well, such as trusts and partnerships, but not corporations.

[3] What follows is a simplified, non-exhaustive list, included for illustrative purposes only.  A full, detailed discussion of Section 1202’s requirements is beyond the scope of this article.

[4] The term qualified trade or business generally means any trade or business other than one involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial or brokerage services, banking, insurance, financing, leasing, farming mining, or hotel/restaurant operations.  See Section 1202(e)(3).

[5] This, and other important estate and gift tax considerations are beyond the scope of this article.

[6] Such statutes exist in many jurisdictions, including for example, New York and Delaware.