How to avoid capital gains on small business stock. The Qualified Small Business Stock (QSBS) exclusion (Under section 1202 of the Internal Revenue Code) was designed to encourage investments in small businesses. Shareholders can exclude up to the greater of $10 million of capital gains or ten times their adjusted basis (Theoretically as much as $499.9 million in gains) in the stock, potentially achieving a 0% capital gains tax rate if shares have been held for at least 5 years and certain requirements are met.
Qualifying for QSBS has several requirements some of which are:
- Company: Must be a domestic C corporation at issuance and throughout most of the holding period. Gross assets of the business must be under $50 million before and immediately after the issuance of stock.
- Business Activity: The company must be engaged in a qualified trade or business, primarily generating revenue from selling goods or services, not passive investments. Certain businesses such as many personal services businesses, many financial services businesses, most hospitality businesses, farms and others are not eligible.
- Investor Requirements: Stock must have been acquired directly from the corporation upon original issuance, not a secondary market purchase. However, gifts and bequests are eligible. Shareholder must be Individual shareholder (not a corporation except for specific trusts and estates) and not a professional service corporation.
- Redemption requirement: In some cases, the benefit is lost if the shareholder redeems any of the company’s stock during a 4-year blackout period or there is a related party sale of the stock.
- State-by-State Considerations: The federal exclusion may not apply in all states. Notable states that do not allow this deduction for state tax purposes are New Jersey and Pennsylvania. Research your state’s tax code to avoid unexpected tax liabilities.
There are several Planning Strategies that can retain or even multiply the benefit such as:
- Early Investment and exercise: Identify promising startups with high growth potential for maximum gain upon exit. If you hold options on qualified stock an early exercise may be advisable to start the clock on the 5-year window.
- Long-Term Commitment: Hold the stock for at least five years to qualify for the exclusion.
- Structuring Investment: Consider forming a qualified trust or estate to potentially qualify for the exclusion even as a corporate investor.
- ‘Stacking’ QSBS stock: Although a requirement for the exclusion benefit is that the original acquirer of the stock should be the seller, gifts and bequests retain the benefit. Strategic gifts to family can multiply the benefit.
- ‘Packing’ QSBS stock: Purchasing high basis QSBS stock (in addition to existing low basis stock) to increase the exemption amount
- Using stock swap to deal with the 5 year holding requirement. As an example, if you swap your QSBS stock for another QSBS stock the 5 year clock continues to tick.
- Professional Consultation: Work with an advisor and tax professionals to plan for this benefit.
By understanding the QSBS exclusion and implementing these planning strategies, investors and entrepreneurs can leverage this powerful tax incentive to unlock significant tax benefits.