Would you like to invest in a business that allows you to subsequently sell your stock tax-free? That may be possible with qualified small business corporation (QSBC) stock that’s acquired on or after September 28, 2010. Sales of QSBC stock are potentially eligible for a 100% federal income tax exclusion. That translates into a 0% federal income tax rate on your profits from selling stock in a QSBC.
Here’s what you need to know about the 100% stock sale gain exclusion rules, including important restrictions and how this deal may be even sweeter under the Tax Cuts and Jobs Act (TCJA).
Tax-Free Gain Rollovers for QSBC Stock Sales
Sales of qualified small business corporation (QSBC) stock may potentially be eligible for a gain exclusion. (See main article.) But that’s not all. There’s also a tax-free stock sale gain rollover privilege — similar to what happens with like-kind exchanges of real property.
Under the rollover provision, the amount of QSBC stock sale gain that you must recognize for federal income tax purposes is limited to the excess of the stock sales proceeds over the amount that you reinvest to acquire other QSBC shares during a 60-day period beginning on the date of the original sale. The rolled-over gain reduces the basis of the new shares. You must hold the original shares for over six months to qualify for the gain rollover privilege.
Essentially, the gain rollover deal allows you to sell your original QSBC shares without owing any federal income tax and without losing eligibility for the gain exclusion break when you eventually sell the replacement QSBC shares.
Whether you’re considering starting up your own business or investing in someone else’s start-up, it’s important to learn about QSBCs. In general, they’re the same as garden-variety C corporations for legal and tax purposes — except shareholders are potentially eligible to exclude 100% of QSBC stock sale gains from federal income tax. There’s also a tax-free gain rollover privilege for QSBC shares. (See “Tax-Free Gain Rollovers for QSBC Stock Sales” at right.)
To be classified as tax-favored QSBC stock, the shares must meet a complex list of requirements set forth in Internal Revenue Code Section 1202. Major hurdles to clear include the following:
- You must acquire the shares after August 10, 1993.
- The stock generally must be acquired upon original issuance by the corporation or by gift or inheritance.
- The corporation must be a QSBC on the date the stock is issued and during substantially all the time you own the shares.
- The corporation must actively conduct a qualified business. Qualified businesses don’t include 1) services rendered in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services or other businesses where the principal asset is the reputation or skill of employees, 2) banking, insurance, leasing, financing, investing or similar activities, 3) farming, 4) production or extraction of oil, natural gas or other minerals for which percentage depletion deductions are allowed, or 5) the operation of a hotel, motel, restaurant or similar business.
- The corporation’s gross assets can’t exceed $50 million immediately after your shares are issued. However, if the corporation grows and exceeds the $50 million threshold after the stock is issued, it won’t cause the corporation to lose its QSBC status with respect to your shares.
This is only a partial list. Consult your tax advisor to determine whether your venture can meet all the requirements of a QSBC.
Gain Exclusion Rules and Restrictions
To take advantage of the gain exclusion break, the stock acquisition date is critical. The 100% gain exclusion is available only for sales of QSBC shares acquired on or after September 28, 2010. However, a partial exclusion may be available in the following situations:
- For QSBC shares acquired between February 18, 2009, and September 27, 2010, you can potentially exclude up to 75% of a QSBC stock sale gain.
- For QSBC shares acquired after August 10, 1993, and before February 18, 2009, you can potentially exclude up to 50% of a QSBC stock sale gain.
The tax code further restricts QSBC gain exclusions for:
C corporation owners. Gain exclusions aren’t available for QSBC shares owned by another C corporation. However, QSBC shares held by individuals, S corporations and partnerships are potentially eligible.
Shares held for less than five years. To take advantage of the gain exclusion privilege, you must hold the QSBC shares for a minimum of five years. So, for shares that you haven’t yet acquired, the 100% gain exclusion break will be available for sales that occur sometime in 2023 at the earliest.
The new tax law makes QSBCs even more attractive. Why? Starting in 2018, the law permanently lowers the corporate federal income tax rate to a flat 21%.
So, if you own shares in a profitable QSBC and eventually sell those shares when you’re eligible for the 100% gain exclusion, the flat 21% corporate rate will be the only federal income tax that the corporation or you will owe.
Right for Your Venture?
Conventional wisdom says it’s best to operate private businesses as pass-through entities, meaning S corporations, partnerships or limited liability companies (LLCs). But that logic may not be valid if your venture meets the definition of a QSBC.
The QSBC alternative offers three major upsides: 1) the potential for the 100% gain exclusion break when you sell your shares, 2) a tax-free stock sale gain rollover privilege, and 3) a flat 21% federal corporate income tax rate. Your tax advisor can help you assess whether QSBC status is right for your next business venture.