Tuesday, January 11, 2022

Qualified Small Business Stock

QSBS is stock in a company where the price appreciates greatly, and when you sell it, you pay NO TAX on your profit!!!!

Also known as Section 1202 stock, QSBS can be a significant planning tool for a startup. 

Because of the potential for reaping big profits at no tax cost, companies that can qualify as a “small business” for this purpose should consider using their stock strategically for attracting investors and rewarding employees.

While the tax break for QSBS is very generous, the definition of it is very restrictive. There are many conditions; the key ones are:

The issuer must be a C corporation in the U.S. (not S corporation).

The corporation’s assets must be $50 million or less at all times before and after the issuance of the stock.

The corporation must be an active business.

The corporation must be in a business other than one involving personal services; banking, insurance, financing, leasing, or investing; farming; mining; or operating a hotel, motel, or restaurant. 

Both the corporation and the shareholder must consent to provide certain documentation for the stock.

The stock must be acquired in exchange for money or property or as pay for services provided to the corporation. 

The statute limits the per-issuer amount that can be excluded to “eligible gain,” which is the greater of:

1) $10 million reduced by any amount the taxpayer excluded from sales or exchanges of QSBS from the same issuer in prior years, or

2) 10 times the aggregate adjusted basis of the QSBS issued by the corporation disposed of by the taxpayer during the taxable year, as measured on the original issue date.

Because the limitation references the higher amount of the two measurements, the potential total gain excluded from gross income may exceed $10 million.  Because a corporation qualifying for the provision could have up to $50 million in assets upon inception,10 the maximum amount of gain eligible for exclusion could reach $500 million under the ten-times-basis limitation.

Section 1202(c)(2) contains an active business requirement, as defined in section 1202(e), for qualified small business stock. 

Section 1202(e)(1)(A) requires that during the relevant period “at least 80 percent (by value) of the assets of such corporation are used by such corporation in the active conduct of 1 or more qualified trades or businesses”. 

Section 1202(e)(3)(A) defines a “qualified trade or business” as any trade or business other than 

(A) any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees,

Important Case Laws:

Case Law: TC Memo 2012-21: Owen v. Commissioner of Internal Revenue "failed the active business requirement."

PLR 201436001 – September 5, 2014 "A biotech company met the definition of a qualified trade or business."

PLR 201717010 – April 28, 2017 "A company that provides laboratory reports to health care professionals met the definition of qualified trade or business."

PLR 201636003 – September 2, 2016 "Paper shares need not be issued for shareholders to qualify for QSBS treatment."

source irs.gov


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