Maximizing Tax-Free Gain Exclusion in Qualified Small Business Stock (QSBS)
The biggest tax bill business owners face is when they sell their business - if you want to minimize that bill - qualified small business stock (QSBS) may be for you.
Under Qualified Small Business Stock, you can have the greater of 10 times your adjusted basis or $10,000,000 of capital gain excluded from tax.
If the date you acquired the stock was prior to September 28th, 2010, then 100% of the gain is eligible for exclusion (& none of that gain is subject to an AMT add-back).
As strong of a tax incentive as this is - there’s provisions around who does & doesn't qualify, those are:
Business must be a U.S. C Corporation
Must be stock issued (common voting/non-voting, preferred voting/non-voting stock)
Corporation cannot redeem/have redeemed stock during a two year-black out period (IRS wants to avoid individuals passing around stock purely for tax savings)
Entity size must be less than or equal to $50M (which would mean the total 10x adjusted basis exclusion would be $499,999,999 of gain exclusion) this includes cash or property used to be exchanged for QSBS.
At least 80% of the asset of the business must be used in the active conduct of 1 or more qualified trades or businesses - a qualified trade or business is anything that is not:
Health, Law, Engineering, Architecture, Accounting, Actuarial Science, Performing arts, Consulting, Athletics, Financial Services, Brokerage Services, Banking, Insurance, Financing, Leasing, Investing (or similar), Farming, Production/extraction businesses, hotels, motels, restaurants (or similar service), Any business where the principal asset is the reputation or skill or one of more employees.
Real property not used in the active business can’t be 10% or more of total assets & stock of other corporations can’t be greater than 10% of company assets unless the corporation is a subsidiary (ownership greater than 50%)
Stock acquisition must be directly from the U.S. C Corporation & stock must be acquired in exchange for:
Cash, property (where basis of QSBS would be the FMV of property), services rendered (stock must be vested)
Eligible shareholders is any person/entity that is not a C Corporation (could be individuals, trusts, partnerships, LLCs, or S Corporations)
Required holding period is 5 years beginning the date of acquisition.
Original owner must generally be the seller (exclusions would be a gift during the owner's lifetime, transferred upon the owner's death, or an in-kind distribution by a partnership to a partner).
Stock sale requirement (typically buyers like asset sales because they have a larger base to deprecation from - with a stock sale, they don’t get the same benefit of deprecation moving forward).
Exhaustive list of exclusion aside - assuming you’re not excluded, here’s some strategies to maximize this benefit.
Ensure you meet the 5-year holding period requirement.
This is straightforward - but not as simple as it may sound.
As a privately held business owner, someone who comes in looking to buy your business for $15M is life changing money.
Do you tell the buyer you’re not interested because you are in the middle of the holding period for QSBS eligibility?
It’s hard to walk away from a sale like that (especially if offer’s aren’t coming your way often).
What you could do is draft an agreement with the existing buyer as a promise to sell in X-years until 5 years, then in exchange you can offer a freeze in sale price, or a conservative growth estimate relative to historical or projected growth to get something on the books.
If your buyer isn’t looking to sign an agreement for a future purchase, you could consider a stock swap.
If you have QSBS for QSBS then the 5-year clock continues and there’s no impact to excludable gain.
If you have QSBS for non-QSBS then the 5-year clock continues to tick but excludable gain is capped at growth above stock basis at the time of swap (ex: exchanging $2M of Nvidia stock that upon future sale is $3M, the $1M of gain is subject to long-term capital gains).
1045 Rollover
This is the QSBS equivalent of an IRA rollover where assuming you’ve owned the QSBS for 6 months, you have 60 days to reinvest proceeds from sale of QSBS into the new QSBS entity.
The hard part of this would be you’d want to do your homework prior to this event because QSBS is hard to come by, this way you’re not running into the 60-day window.
QSBS Stacking
Through gifting your shares to children, parents, siblings, other individuals, incomplete non-grantor trusts you multiply your exclusion as QSBS is PER TAXPAYER PER BUSINESS.
An example of this could be someone who started a business with $100,000 of their own capital, that QSBS-eligible business then grew to $50M upon sale, that business owner could gift $10M to each of their 4 children (of which the greater of 10x adjusted basis or $10M is excluded) so all $50M of gain is tax-free instead of having only $10M tax-free and $40M taxable.
Big win.
Granted - if this is something you’re looking to take advantage of, the IRS does have measures in place to prevent events like this from occurring (assignment of income issues) so you’ll want to leave as much space and time as possible between the gift and the sale so this looks as clean as possible in the eyes of the IRS.
If you already have a deal pending or on the docket & you’re looking to do this, you’ve already missed the opportunity.
Further, you’ll want to be mindful of the gift tax exemption. Gifts over $13.61M in 2024 are taxed at 40%.
Using both exclusions amounts
QSBS has two exclusions:
10x adjusted basis or $10M dollars - the two can be mutually exclusive.
You can use the $10M exclusion in one year - then use the 10x adjusted basis in another year.
Consider the following:
You invest $40,000 in XYZ, Inc. in exchange for 4,000 shares of the business ($1/share).
XYZ, Inc. grows to $4M.
XYZ, Inc. raises additional capital and you invest $400,000 in XYZ, Inc. for another 1,000 shares ($400/share).
XYZ, Inc. increases in value to $20M.
If you sell everything in year 1 and you would have $10M of gain excluded.
Or you could split the sale over 2 years (December 31st & January 1st).
December 31st year, you sell your low-basis QSBS (& get the $10M), then the following year, you sell your high-basis QSBS (& get 10x basis).
In this case, you increase the total amount of gain that can be excluded.
This works because there were multiple tranches of basis through multiple fund-raising rounds.
If you’re a single basis shareholder, you’re not fully excluded…
You could raise capital (from yourself) and contribute another trache of capital in exchange for additional QSBS.
This would allow for 10x that contribution amount to be excluded tax-free.
Entity conversions for future QSBS
This needs to be done before the business exceeds $50M in value.
It’s important to note that the value of the initial contribution is not eligible for gain exclusion.
If the business is worth $5M and you convert to a C-corp, that $5M is not eligible for QSBS. This would be best applicable to businesses that are expected to grow considerably in value (if not already started as a C-corp).
If you’re a partnership looking to move to a C-corp this would be done through a “formless” conversion.
If you’re a S-corp looking to move to a C-corp this would involve an F-reorganization or recapitalization with preferred stock.
Provided the tax cuts and jobs act moved C-corp tax rates down to 21% and there is no AMT add back (like there was in the early 90s when QSBS was introduced) this presents a great time in history to use QSBS.