One important way that business owners can mitigate capital gains taxes on stock appreciation is to utilize the qualified small business stock (“QSBS”) rule.  For many early stage founders and investors, this rule is highly advantageous because the value of their stock is often very low when it is acquired and can (hopefully) rapidly increase as the business is successful.  There are a few ins and outs that you should discuss with your attorney or tax advisor depending on your specific situation, however we highlighted a few points below for you to keep in mind in case you are wondering whether or not your business qualifies.

qualified small business stock

What are the Advantages of QSBS?

First, QSBS is designed, in part, to help promote investments into small businesses. Through tax incentives, investors and entrepreneurs alike are presumably more inclined to make investments of the sort if they know that there is the possibility of receiving significant tax advantages by doing so.

Second, while stockholders are typically required to pay capital gains taxes on the increase in the stock’s value when they sell, utilizing QSBS, if done correctly, allows stockholders to mitigate those taxes by at least 50%, and in some instances up to 100%. The tax advantages can be very beneficial to those early shareholders, who typically represent the founders and early investors in the business.

What are the Rules for QSBS?

    1. The Company must be a corporation. QSBS only applies to stock originally issued by C corporations (not S corporations) and acquired as such (i.e. the stock cannot be sold on a secondary market). So, if your small business is an LLC or partnership, you will not be able to qualify unless you convert the entity to a corporation.
    2. The Company must qualify as a “small business”. If the Company’s assets are over $50mm, then QSBS will likely not apply.
    3. The shareholder must be an actual human person. QSBS does not apply to corporations or other legal entities that own stock and are looking to take advantage of certain tax savings.
    4. The stock must be held for at least 5 years. QSBS is designed for long term investments in small businesses. As such, to the extent a stockholder is looking to sell shares before this window, she may not be able to take advantage of the QSBS tax advantages.
    5. The stock must have been “purchased”. The purchase of the stock must have been made with cash, property or as payment for services rendered. Therefore, gifts of stock that may otherwise qualify for QSBS treatment may not receive the same advantages once given to a recipient. This rule is designed, in part, to discourage folks from designing creative estate planning mechanisms which may not align with the designed purpose of QSBS.
    6. The Company has restrictions on certain activities. A minimum of at least 80% of the issuing-corporation’s assets, during the stockholder’s 5-year holding period, must be used for a qualified, “active” trade or business and only up to 10% may be held in real estate that is not being utilized in the business’s active operations.
    7. The Company must be in certain industries to qualify. If the Company is in one of the following industries, it may not qualify for QSBS: accounting, architecture, engineering, performing arts, health, hotel service, legal, restaurant, or financial services industries, or any other type of business in which the main asset is the specialized skill of the business person or his employees.*
    8. The amount of tax advantages depends on when the shares were issued. For corporations that meet the requirements, stock that was issued between August 11, 1993, and February 17, 2009, can benefit from a 50% capital gains tax exclusion under QSBS. For corporations that meet the requirements and issued stock between February 18, 2009, and September 27, 2010, a 75% capital gains tax exclusion applies.  Finally, for corporations that met the requirements and issued stock after September 27, 2010 a 100% capital gains tax exclusion applies.
As you can see, utilizing the QSBS rules can offer significant advantages to founders and investors in early-stage businesses.  Although this strategy could provide a substantial benefit for you, it is important to remember that there are a number of factors to consider when deciding what entity type is the best for your business or whether your investment qualifies.  If you have any questions, please feel free to contact the attorneys at Fourscore Business Law.

*Please consult with your lawyer for a comprehensive overview regarding whether your business type will qualify.
Categorized: New Founders