Would you be interested in investing in a business that allows you to later sell your stock tax-free? It may be an option for qualified small business corporation (QSBC) stock that was acquired on or after September 28, 2010. Sales of QSBC stock may be eligible for a 100% federal income tax exclusion. That would be a 0% federal income tax rate on your profits from selling your QSBC stock.
This deal may be even sweeter under the Tax Cuts and Jobs Act (TCJA). Here is what you need to know about the 100% stock sale gain exclusion rules, including important restrictions.
It’s important to learn about QSBCs whether you’re considering starting up your own business or investing in someone else’s start-up. Generally speaking, QSBCs are the same as a standard C corporation for legal and tax purposes, but shareholders are potentially eligible to exclude 100% of QSBC stock sale gains from federal income tax. QSBC shares also have a tax-free rollover privilege.
In order to be classified as a tax-favored QSBC stock, the Internal Revenue Code Section 1202 sets forth a complex list of requirements the shares must meet. The key elements include:
- The shares must have been acquired after August 10, 1993.
- The stock must generally 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 do not 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 not exceed $50 million immediately after the shares are issued. However, if the corporation grows and exceeds the $50 million threshold after your stock is issued, this won’t cause the corporation to lose its QSBC status with respect to your shares.
These are only some of the requirements. Consult with your tax advisor to determine whether your venture could meet all the requirements of a QSBC.
Tax-Free Gain Rollovers for QSBC Stock Sales
As mentioned above, sale of qualified small business corporation (QSBC) stock may theoretically be eligible for a gain exclusion. But that’s not all. There is also a tax-free stock sale gain rollover privilege — much like what occurs 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. The original shares must be held by you for over six months to qualify for the gain rollover privilege.
So the gain rollover deal can enable you to sell your original QSBC shares without owing any federal income tax and without losing your eligibility for the gain exclusion break when you eventually sell the replacement QSBC shares.
Gain Exclusion Rules and Restrictions
In order to take advantage of the gain exclusion break, the stock acquisition date is critical. The 100% gain exclusion is possible only for sales of QSBC shares acquired on or after September 28, 2010. However, acquisition earlier than that may make a partial exclusion available:
- 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 additionally restricts QSBC gain exclusions for:
C corporation owners. Gain exclusions are not available for QSBC shares owned by another C corporation. But 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 have the QSBC shares for a minimum of five years. Thus, for shares that you haven’t yet acquired, sales occurring 2023 are the earliest the 100% gain exclusion break would be available.
The new tax law makes QSBCs even more attractive. Why? Beginning in 2018, the law permanently reduces the corporate federal income tax rate to a flat 21%.
Thus, if you own shares in a profitable QSBC and ultimately 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 you or the corporation will owe.
Right for Your Venture?
The 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 hold true if your venture meets the definition of a QSBC.
The QSBC alternative offers three major advantages: 1) 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. Talk with your tax advisor to help you assess whether QSBC status is right for your next business venture.