Lido Insights

20 January 2022

The Recent Rise in Popularity of the Qualified Small Business Stock

By Olivia Zaiya, Esq., CFP®, Wealth Strategies

First, what is Qualified Small Business Stock and why is it important?

The IRS allows taxpayers who have stock in qualified small business companies to avoid up to $10 million in capital gains taxes, the 3.8% net investment tax, and the alternative minimum tax on the sale of those shares. A taxpayer with QSBS can sell $10 million of that stock and pay zero federal taxes on that sale, potentially saving millions. Many states also allow a full state tax exemption but notably CA, PA, AL, and MS do not.

For the gain on the sale of stock to be eligible for this substantial tax exclusion, the following requirements must be met:

The Date Requirement. The taxpayer acquired the stock after Sept. 27, 2010, for the 100% deduction. Stock held before this time may qualify for a smaller deduction (50%-75%).

The Small Business Requirement. At all times before and immediately after the issuance of the taxpayer’s stock, the corporation’s adjusted basis in its assets must not exceed $50 million.

The Original Issuance Requirement. The taxpayer’s stock must be original issuance, received directly from the company—it cannot be purchased through a secondary market.

The Holding Requirement. The taxpayer must hold the stock for at least five years.  For stock options the five-year period starts once the option is exercised. There is the ability to exchange one QSB stock for another QSB stock before the five year holding period.

The Qualified Business Requirement. At all times during the taxpayer’s holding period, the issuing company must be actively engaged in a qualified trade or business. Generally, most professional service businesses such as finance and investment management businesses and hospitality businesses are disqualified.

The C-Corp Requirement. The company must be a U.S. C corporation.

Until recently, the last requirement has been the most prohibitive for start-ups to use QSBS as a tax strategy. Businesses structured as C-corps are subject to double taxation, first at the corporate level then again at the individual level when distributions are made to the taxpayer. Unless a business had to be a C-corporation for other reasons, it was typically not advised for a start-up to structure as a C-corp when more favorable tax structures existed. S-corps, partnerships and LLCs are all pass-through entities, meaning they do not pay the corporate tax—they are taxed at the taxpayer level only. However, the passage of the Tax Cuts and Jobs Act significantly reduced the corporate tax rate from 35% to 21%.

This changed the game. Now, if earnings can be retained and reinvested in the business and the individual tax can be avoided by using the QSBS provisions, the choice of entity for founders and other investors has fundamentally shifted. Structuring a start-up as a C-corp for the purposes of taking advantage of the QSBS exemption is becoming increasingly more popular. QSB stock can also be very appealing to early-stage investors, which may help start-ups businesses acquire capital. QSB stock can save entrepreneurs, executives, and investors millions of dollars in taxes. This, combined with creative estate planning strategies can actually increase the $10 million dollar cap on the exclusion exponentially since the $10 million dollar cap is per person.

As an innovative wealth management firm, Lido Advisors strives to add value in the areas of estate planning, tax considerations and investment management. We dedicate our resources to the development of innovative, creative, and cutting-edge solutions for executives and entrepreneurs. If you are interested in discussing this strategy or others with our team of advisors and affiliated professionals, contact us here.

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