Some businesses can issue stock that entitles owners to eventually obtain tax-free income when they sell their stock. Yes, 100% of gain on the sale of qualified small business stock, or QSBS (also called Section 1202 stock after the section in the Tax Code governing it) may be excludable from gross income. But there are many restrictions that limit the utility of this wonderful stock break.
Here are 10 rules to note:
1. The corporation must be a C corporation
An S corporation cannot issue qualified small business stock. The corporation must be a regular corporation, meaning a C corporation.
With the cut in the corporate tax rate to a flat 21%, some businesses now operating as limited liability companies, partnerships, or S corporations, may want to become C corporations. Doing so gives owners access to QSBS stock. But there’s a trap for S corporations that terminate or revoke their S election to become C corporations. The law says the corporation must be a C corporation on the date the stock is issued. So the C corporation that exists following a termination or revocation of the S election must issue new shares.
Example: An S corporation with 2 shareholders revokes its S election effective January 1, 2019. The shareholders must each contribute cash, property, or services in exchange for shares. Newly issued shares will qualify as Section 1202 stock.
Some tax experts have suggested that current S corporations should transfer their assets to a C corporation in a tax-free exchange (called a Section 351 exchange). Then the S corporation could hold onto the newly issued C corporation stock to allow for gain on future sales. This suggested arrangement is complicated and not for the uninformed.
2. The corporation can’t be involved in certain industries
Basically, the corporation cannot be one involving personal services (e.g., those performed in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services); banking, insurance, financing, leasing, or investing; farming; mining; or operating a hotel, motel, or restaurant.
So which businesses can qualify: those involved in manufacturing, retailing, technology, and wholesaling.
3. The stock usually must be acquired from the corporation
Shareholders must acquire their stock for cash, property, or as payment for services from the corporation (those acquiring QSBS as a gift or inheritance can still get the tax break). At year end, if your corporation is a qualified small business, you can give bonuses to employees (including owner-employees) in the form of stock. The stock given as a year-end bonus is includible in gross income as long as there are no restrictions on it, so employees pay income tax on it (and the value of the stock at issuance is subject to employment taxes). But future appreciation can be transformed into tax-free income.
4. The corporation must be a domestic corporation
On the date the stock is issued, the corporation must be a domestic corporation. Foreign corporations operating in the U.S. cannot issue qualified small business stock.
5. The corporation must be of a certain size
As of the date the stock was issued, the corporation must have total gross assets of $50 million or less. This asset limit applies prior to issuance and immediately after issuance of the stock. Gross assets include those of any predecessor of the corporation. All corporations that are members of the same parent-subsidiary controlled group are treated as one corporation.
6. The corporation must be an operating corporation
The corporation can’t be a mere holding company; it must be engaged in a business within a permissible industry. At least 80% of the value of the corporation’s assets were used in the active conduct of one or more qualified businesses (see #2 above).
7. The amount of the exclusion depends on when the stock was issued
The amount of gain excludable depends on when the stock was acquired:
- A 100% exclusion of gain applies for stock acquired after September 27, 2010.
- A 75% exclusion of gain applies for stock acquired after February 17, 2009, and before September 28, 2010. 50% exclusion of gain applies for stock issued before February 19, 2009.
8. Stock must be held long enough
Regardless of when the stock was issued, it must have held it for more than 5 years to obtain an exclusion.
9. The amount of gain excludable is capped
The exclusion cannot be more than the greater of $10 million ($5 million for married persons filing separately), minus any gains excluded in prior years, or 10 times the shareholder’s basis in QSBS. Lower limits applied to married persons filing separately.
10. The excluded gain impacts other tax rules
The excluded gain has consequences beyond tax-free income.
- The portion of the gain not excluded on stock issued prior to September 28, 2010, is taxed at a capital gain rate of 28% (not the usual 15% or 20% on most other long-term capital gains).
- The excluded gain is not treated as investment income in figuring the limit on the itemized deduction for investment interest.
- The exclusion is not taken into account in figuring a net operating loss deduction.
Final thought
You can see from this list of conditions for QSBS, the potential benefit (tax-free income) is significant but the rules are complicated. You need to work with your CPA or other tax adviser to do things right.
