By: Benjamin Jacob
The Qualified Small Business Stock (QSBS) exclusion provided for under Section 1202 of the Internal Revenue Code grants compelling tax benefits to qualifying stockholders. To take advantage, it is imperative to be clear on the statutory requirements for eligibility and what type of transactions will disqualify stock from receiving QSBS treatment. In a previous post, we provided a general overview of the qualified small business (QSBS) exclusion. In this post, we’ll focus on the basic QSBS eligibility requirements and what type of transactions disqualify stock from receiving QSBS treatment.
For stock to receive QSBS treatment, there are 6 basic requirements.
- The stock must be received by an eligible taxpayer. Generally, only C corp stockholders are ineligible to claim a QSBS exclusion.
- The stock must be held for at least 5 years.
- The stock must have been originally issued to the stockholder. This means it was issued directly from the corporation to the stockholder, not purchased by the stockholder on a secondary market.
- The stock must have been issued after August 10th, 1993.
- The stock must have been acquired for consideration meaning cash, services, or other eligible property.
- The stock must have been issued by a “qualified small business” (see below)
To be a “qualified small business” within the meaning of Section 1202, the following requirements must be met:
- C Corp. The issuing business must be a C corporation.
- Actively running a business. Generally, during the period the QSBS stock was held, at least 80% of the assets must be used for the company’s business or trade.
- Qualified Business. Business is a “qualified trade or business” according to IRC 1202 (e)(3) (certain service businesses are not eligible).
- Asset cap. Aggregate assets since 1993 have never exceeded $50,000,000.
Under IRC § 1202 (c) (3), there are certain types of stock redemptions that, if transacted by the issuing corporation, will automatically disqualify stock from receiving QSBS treatment. From a policy perspective, this is aimed at preventing corporations from redeeming and reissuing stock that would otherwise qualify for QSBS treatment.
Stock will not qualify for QSBS treatment if:
- Subject to de minimis redemption exceptions, the issuing corporation purchased any stock from the holder or a related person at any time during the four-year period beginning two years prior to the issuance of the stock in question; or
- The issuing corporation made one or more purchases of its stock with an aggregate value exceeding 5% of the aggregate value of all of its stock (as measured at the beginning of the period) during the two-year period beginning on the date one year before the issuance of the stock.
Documenting for QSBS Treatment
Shareholders and corporations need to have sound documentation in place to protect shareholders’ QSBS exclusion in the event the claim is subjected to IRS scrutiny.
From a shareholder standpoint, it is generally good practice to have documentation of:
- The consideration paid in exchange for the QSBS
- Company certification that they meet the asset requirement (less than $50,000,000 in assets) immediately after the share purchase
- Company certification that at least 80% of the company’s assets are used and will continue to be used in the active conduct of the business for at least the required holding period
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