Saving Tax Dollars with Qualified Small Business Stock (QSBS)
By elizabeth cody, CFP®
September 17, 2024
If you hold qualified small business stock (QSBS) and are thinking of starting or investing in a new venture, consider rolling your capital gain associated with your current QSBS into the new enterprise.
In the spirit of incentivizing continued investment in small businesses, the Internal Revenue Code allows individuals to defer the capital gains tax due on the sale of QSBS stock if, during the 60 days following the original QSBS sale, proceeds are used to purchase shares of a company that qualifies for QSBS. This rollover treatment is only available if you have held the original stock for more than six months and you make a special election on your federal income tax return for the year of sale.
If properly coordinated, the taxpayer will only recognize gain to the extent that the amount realized on the sale exceeds the cost of any new QSBS purchased during the 60-day replacement period. The amount of deferred gain reduces the basis in the replacement QSBS, allowing any gain not recognized currently to be deferred, not excluded.
By way of background, the QSBS break dates to 1993—stock acquired between August 11, 1993 and February 17, 2009 is eligible for a 50% gain exclusion, subject to a 7% addback for alternative minimum tax. The rule was later amended such that stock acquired between February 18, 2009 and September 27, 2010 became eligible for a 75% gain exclusion, with the AMT addback. Then in 2010, Congress passed the Creating Small Business Jobs Act of 2010, which included an amendment providing for a 100% U.S. federal income tax exemption, without AMT addback, on the sale of QSBS.
For the investment in the new company to qualify for this rollover, the new startup must, on its own, qualify for QSBS. To qualify for QSBS:
The stock must be in a domestic C corporation (not an S corporation or LLC, etc.), and it must be a C corporation during substantially the entire holding period.
The corporation may not have more than $50 million in assets as of the date the stock was issued and immediately after.
Your stock may not have been acquired from a secondary market offering, but instead must be an original issuance.
During the holding period, at least 80% of the value of the corporation’s assets must be used in the active conduct of one or more qualified businesses.
Most early-stage investments in C-corporation technology companies meet these requirements.
QSBS can be used to attract both employees and investors. Young companies need to carefully manage their cash, so limiting cash compensation by issuing QSBS to employees and third-party providers can be an attractive strategy. Additionally, employees holding a stake in a young company are incented to build the company. Investors are incented to make investment at an early stage and may benefit from the tax breaks provided to holders of QSBS. It is important to note that gains derived from the sale of QSBS are exempt from the federal 3.8% net investment income tax. California, however, eliminated the QSBS gains exclusion on stock sales on or after January 1, 2013, so though the federal tax advantage exists, California state capital gains tax rules will apply in these situations.
Documentation and timing are critical in successfully claiming the tax benefits of QSBS. It is important to keep exact records and consult your accountant and Wealth Manager before selling your shares, particularly if you plan to invest the proceeds in a new venture.
Source: www.irs.gov
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