By Michael Torney, CFP, J.D., LL.M.
Founders of small businesses have many tax benefits while running their business. They also may qualify for some tax advantages when selling the business. Certain kinds of company stock have an unusual benefit: In certain cases, it enables a person to avoid paying capital gains taxes on the stock’s gains as long as the stock meets certain requirements.
What is Qualified Small Business Stock and Who Is Eligible?
Referred to as qualified small business stock (QSBS), this is nothing more than the stock of a private company that meets certain additional requirements. What makes a company eligible?
First, the company must be an active United States corporation with a “C” tax status and whose assets do not exceed $50 million at the time of stock issuance. The stock must have been issued after August 10, 1993. The stock must be held for five years prior to sale.
In addition, only certain types of companies fall under the category of a QSBS. Firms in the technology, retail, wholesale, and manufacturing sectors are eligible as QSBs, while those in the hospitality industry, personal services, financial services, farming, and mining are not.
Finally, only stock equity qualifies. Stock options, warrants, phantom stock, etc. will not qualify.
How the Tax Benefits Work
The tax treatment for a QSBs depends on when the stock was acquired and how long it is held. However, in many cases, if the holder acquires the stock after Sept. 27, 2010, they can exclude taxes up to 100% of the stock’s capital gains. This exclusion applies to federal taxes. States also have QSBs tax rules but vary depending on state law. For example, New Jersey and California are two states that do not provide for a QSBS exclusion at the time of this writing.
For example, if an owner was issued company stock on Sept. 30, 2010, and sold it five years later, they do not have to pay any federal tax on their capital gains. That includes the 3.8% net investment income tax, alternative minimum tax, and capital gains tax.
However, if the stock was acquired before September 26, 2010, a smaller percentage can be excluded from the capital gains tax — either 50% or 75%, depending on the acquisition date, and a portion of the gains may be subject to the alternative minimum tax.
If for some reason the executive decides to sell their shares before the end of the required holding period, they can defer capital gains by investing the proceeds in another company’s QSBS. It’s important to consult a qualified tax advisor if when considering selling before the holding period requirements.
The federal capital gains exclusion is limited to $10 million or ten times the adjusted cost basis—whichever is greater. Once that amount is exceeded, any gains on the sale will be taxed at regular capital gains rates.
A few states have their own laws and do not exclude QSBS from state taxes. If your company is incorporated in one of these states, you aren’t eligible for QSBS exclusion at the state level.
If you think your company might qualify for the Qualified Small Business Stock tax treatment and you would like to discuss it as part of an overall financial strategy, contact our team at DuffTorneyteam@monetagroup.com. We offer a free consultation and are always available to discuss how we can help people maximize their wealth.
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