Qualified Small Business Stock

What Is Qualified Small Business Stock (QSBS)?

A Qualified Small Business Stock (QSBS) refers to the equity shares that offer various tax benefits to shareholders, given they meet specific additional requirements. These are issued by qualified small businesses (QSBs), as defined by the Internal Revenue Service (IRS).

Internal Revenue Code (IRC) section 1202 allows investors to hold stock in active domestic C corporations that qualify as small businesses, with a maximum asset value of $50 million when the stock is issued. Capital gains arising from QSBS investments are typically exempted from federal taxes.

• Qualified small business stock is defined as the equity shares issued by qualified small businesses with assets totaling less than $50 million, according to Section 1202 of the Internal Revenue Code (IRC). 
• It provides investors with tax benefits, and they may even qualify for total exemption from capital gains tax if they hold the stock for more than five years and meet other specific conditions. 
• The tax exemption level depends on both the time of stock acquisition and the duration of the stock holding by the investors.

How Does Qualified Small Business Stock Work?

Qualified Small Business Stock (QSBS) refers to a specific category of equity shares issued by qualified small businesses (QSBs). QSBs are typically organized as C corporations, meaning they are taxed separately from their owners and are domestic companies operating within the United States. These businesses must not have total assets exceeding $50 million, as mandated by the Internal Revenue Code (IRC).

Investors looking to hold shares in QSBs can benefit from Section 1202 of the IRC, which provides essential guidelines and incentives. This section allows small businesses to raise capital from the public market and expand their operations. Moreover, it offers tax breaks and exemptions to investors, which are further detailed in subsequent sections of the code.

It's important to note that only specific industries qualify as QSBs. Manufacturing, technology, retail, and wholesale firms fall within the eligible category. Conversely, businesses engaged in health, farming, mining, personal, and financial services sectors are exempt from the QSB definition. Additionally, businesses primarily reliant on the skill or reputation of one or more employees are not considered qualified small businesses.

Requirements

The following are the requirements that an investor and the Qualified Small Business (QSB) should meet to qualify for tax exemptions on Section 1202 Qualified Small Business Stock (QSBS):

1. The shareholder should have held the QSBS for at least five years.
2. The shareholder should not be a corporation.
3. The shareholder should have purchased the QSBS at its original issuance in the primary market, not from the secondary market.
4. The shareholder should have acquired the QSBS using cash or assets or received it as payment for their services.
5. At least 80% of these small businesses' assets should be used to conduct a qualified trade or business actively.
6. Investors can be exempt from gross income capital gains tax up to a $10 million cumulative limit and an annual exclusion of 10 times the basis of the QSBS sold that year. The greater of the two limitations applies to both the investor and the issuing company.

It's crucial to meet all these requirements for investors to qualify for the tax exemptions associated with Section 1202 QSBS.

Examples

Let us discuss a few examples of QSBS.

Example #1

Tessa purchased 100 stocks from Co. X, a QSB, on February 01, 2010. She sold these stocks on February 10, 2023, and earned $30,000 in capital gains. It makes her eligible for the 75% capital gains exclusion. Her total taxable income is $50,000. So, let us check how much she pays as capital gains tax upon the sale of qualified small business stock.

Since her taxable income is $50,000, her capital gains tax would be 15%. Her capital gains would be calculated as follows:

(75% x 30,000) x 15%

= $3,375

Example #2

The American Institute of Certified Public Accountants (AICPA) sent a set of 61 proposals to Congress, suggesting specific changes to the internal revenue code in terms of word meanings. The AICPA proposed that the definitions of particular terms be standardized throughout the Code. One such proposal concerns the ambiguity in the term 'small businesses.'

In Section 263 A, small businesses refer to those having $10 million or less in gross receipts. In section 448, the term refers to businesses having $25 million or less in gross receipts. Under Section 1202, businesses having less than $50 million in total assets are considered small businesses. It also suggested harmonizing education-related tax provisions and issuing uniform provisions to aid taxpayers in disaster relief situations.

Tax Exemption

When tax exemptions allow individuals to pay disproportionately lower taxes considering their income level, an alternative minimum tax (AMT) is charged to them. Also, a net investment income (NII) tax is imposed at 3.8% of the difference between the modified adjusted gross income and NII thresholds.

Here are the tax exemptions for QSBS shareholders:

1. If a person buys a share from a QSB after September 27, 2010, they will receive a 100% capital gains exemption. The investor will also be excluded from the AMT and NIIT.
2. If a person bought a share from a QSB after February 18, 2009, but before September 27, 2010, they are eligible for a 75% capital gains exclusion. Further, 7% of the exempted gain is subject to AMT.
3. If a person bought a share from a QSB after August 11, 1993, but before February 18, 2009, they are eligible for a 50% capital gains exclusion. Further, 7% of the exempted gain is subject to AMT.

The investors should remember that they qualify for these exemptions only if they satisfy all the requirements mentioned.

Frequently Asked Questions (FAQs)

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