Article | November 16, 2023

by Horty & Horty, P.A.

Qualified small business stock (QSBS) is a tax incentive designed to promote investment in small businesses while offering substantial tax benefits to investors and founders. Section 1202 of the Internal Revenue Code allows eligible owners of QSBS to exclude a significant portion of their capital gains, net investment income tax (NII), and alternative minimum tax (AMT) from federal taxation. 

However, to fully capitalize on these valuable tax advantages, it’s crucial to understand some of the nuances of QSBS. 

Core benefits of qualified small business stock

One of the most notable benefits of QSBS is the ability to reduce federal income tax liabilities by excluding certain gains from the eventual sale of stock. 

The 100% exclusion rule allows eligible investors to exclude up to 100% of their capital gains realized from the sale of QSBS, up to $10 million cumulatively or ten times your basis for any QSBS sold during the year. In some cases, eligible investors may also be able to exclude up to 100% of their Alternative Minimum Tax (AMT) and Net Investment Income Tax (NII) related to the gains. 

The tax benefits vary based on when the stock was acquired: 

  • A 100% capital gains, AMT, and NII exclusion is available for QSBS acquired after September 27, 2010. 

  • A 75% capital gains exclusion is available for QSBS acquired between February 18, 2009, and September 27, 2010. However, 7% of the excluded gain is subject to the AMT.

  • A 50% capital gains exclusion applies to QSBS acquired between August 11, 1993, and February 17, 2009, with a similar 7% of the excluded gain subject to AMT. 

Common misunderstandings

Common misconceptions about QSBS often stem from mistakes about eligibility criteria, holding periods, and exclusion limits. 

Eligibility criteria

Firstly, not all small business stock automatically qualifies for QSBS status. 

To qualify, the stock must be obtained directly from a C corporation. The issuing corporation’s status as a C corporation must be maintained from issuance to sale, and only certain companies fall under the category of a qualified small business (QSB). While firms in technology, retail, wholesale, and manufacturing sectors are eligible, those in industries like hospitality, personal services, financial services, farming, and mining are typically ineligible. 

Also, the issuing company must have less than $50 million in gross assets when the stock is issued, and at least 80% of the company’s assets must be actively used in a trade or business, not in passive investments. 

Stockholders must also meet certain qualifications. To take advantage of the Section 1202 gain exclusion, the stock must be held by individuals, trusts, or pass-through entities, such as partnerships or S corporations. Additionally, the stock must have been acquired at its original issue, not on the secondary market. 

Holding period

An eligible taxpayer must hold the stock for at least five years to qualify for the full exclusion. 

Exclusion amount

Additionally, investors sometimes overlook the limit on the exclusion amount. The $10 million limit is cumulative, meaning it applies over the lifetime of your investments in QSBS. The ten times adjusted basis limit is annual and is calculated as ten times the adjusted basis in the QSBS stock sold during the tax year. 

Likewise, calculating the adjusted basis can be complex as it depends on various factors, including the original purchase price, any additional investments, and certain adjustments. Your adjusted basis can change over time, necessitating careful consideration to ensure you’re maximizing the annual exclusion without exceeding it. 

Common pitfalls

Failure to properly track and document

One of the most common pitfalls is the failure to maintain accurate records and documentation related to QSBS. Properly tracking the acquisition, holding period, and basis of QSBS is essential to claim the tax benefits. Inadequate documentation can lead to compliance issues. 

Inadvertent disqualifications

Many individuals inadvertently disqualify their QSBS by engaging in activities or transactions that jeopardize its status. This can include accumulating too many passive assets or engaging in prohibited activities.

For instance, if a QSB later expands into an industry that is a disqualified sector, it could jeopardize the eligibility of the stock. 

Rollover errors

QSBS investors may have opportunities to defer gains through Section 1045 rollovers, allowing them to reinvest the proceeds from the sale of QSBS into new QSBS without immediate tax consequences. However, this aspect of QSBS can be problematic if not understood and executed correctly. 

First, investors must reinvest the proceeds from the sale into another QSBS within a 60-day window. Failing to meet this deadline can lead to capital gains taxes (if the stock was not held long enough). The rollover provision is also contingent on reinvestment in another QSBS. If the new investment does not meet all of the necessary criteria, the gain will not be deferred. 

State tax reporting mistakes

QSBS tax treatment can vary at the state level, and some states may not conform to federal rules. Failing to understand and comply with state-level tax implications can lead to unexpected tax liabilities or missed opportunities for tax savings. 

Navigating the complexities of QSBS requires a deep understanding of relevant tax laws. The potential tax savings are significant, but there are many moving parts and rules that must be followed diligently. An experienced tax professional can provide valuable guidance on eligibility criteria, holding periods, exclusion limits, and other critical aspects of QSBS to help you reap the full benefits of the tax exclusions. For more information, please contact our office to speak with one of our expert advisors.

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