Qualified small business stock

An attractive tax planning tool for business owners and their families

Under the right circumstances, qualified small business stock (QSBS) offers tax savings for business owners. Essentially, QSBS allows them (and their heirs) to sell their stock free of capital gains tax. This tax break is subject to several strict requirements, but the benefits can be substantial for those who qualify.

What is QSBS?

QSBS was created by Internal Revenue Code Section 1202 and initially allowed qualifying taxpayers to exclude 50% of their capital gain from the sale of QSBS. That amount temporarily increased to 75% in 2009 and 100% in 2010. In 2015, Congress made the 100% exclusion permanent for QSBS acquired after September 27, 2010.

To qualify as QSBS, a U.S. C corporation must issue the stock to an individual or pass-through entity. In addition, the issuer must be:

1. A Small Business
   The business’s aggregate gross assets must not exceed $50 million after August 10, 1993, or immediately after the stock is issued. If the issuer owns more than 50% of another corporation’s stock, the subsidiary’s assets are included for purposes of the gross asset test. A corporation is not disqualified if its assets grow beyond the threshold after issuing the stock.
2. An Active Business
   The business must use at least 80% of its assets (by value) to conduct one or more qualified active businesses. In addition, no more than 10% of its assets can consist of nonbusiness real estate.

A qualified active business is any trade or business other than:

• Service businesses in the following fields: health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services and brokerage services;
• Banking, insurance, financing, leasing, investing and similar businesses;
• Farming businesses;
• Certain oil, gas and mining businesses; and
• Operators of hotels, motels, restaurants and similar businesses.

Beware: The QSBS exclusion applies only to federal income tax. Some states do not follow Sec. 1202, so state-level taxes may still apply.

Who qualifies for the tax break?

To qualify for the favorable treatment, a shareholder must not be a C corporation and must acquire the stock as part of an original issuance. In other words, the shareholder must acquire the stock directly from the corporation (or through an underwriter), not from another shareholder, in exchange for money, property (other than stock), or as compensation for services. This requirement has certain exceptions, including for stock received by gift or inheritance.

In addition, the taxpayer must hold the stock for at least five years after issuance. However, if the stock is received by gift or inheritance, the transferor’s holding period is added to the recipient’s.

If QSBS is converted into a different stock of the same corporation, the original stock’s holding period is added to the new stock’s holding period. If the stock is sold in less than five years, the taxpayer can preserve the tax benefits by rolling over the gain into another QSBS within 60 days.

This exclusion is not unlimited, however. The amount of QSBS gain on a particular issuer’s stock that a taxpayer may exclude each year is limited to the greater of 1) $10 million, or 2) 10 times the taxpayer’s aggregate adjusted tax basis in stock sold during the tax year.

Is it right for your business?

QSBS offers significant tax benefits, but it is not for everyone. It is important to weigh the advantages of tax-free capital gains against the disadvantages (including double taxation of dividends) of operating as a C corporation. Your tax advisor can help answer any questions.

Tax Tips

Navigating business-vehicle expense deductions can be tricky

If you operate a business, you can generally deduct expenses for the business-related use of your personal vehicle. There are two ways to determine the portion of your overall expenses that is attributable to your business use for the current year: 1) the actual expense method, or 2) the standard mileage rate.

The actual expense method allows you to deduct expenses attributable to business use of the vehicle, including gas, insurance, and license and registration fees. Alternatively, you can use the standard mileage rate approved by the IRS. This figure is updated annually. The rate is 67 cents per mile for 2024. If you use this method, it is critical to keep detailed records, including the mileage for each trip and the business purpose of the travel.

Have you made contingency plans for your beneficiaries?

Sometimes the best laid estate plan can go awry. This can happen if a beneficiary predeceases you. To avoid having state law dictate who receives your property, name contingent beneficiaries on retirement accounts and insurance policies. In addition, ensure that your will or trust is clear on what happens if an heir predeceases you.

Suppose you are splitting your assets equally between your two children. If one of them dies, what happens to their share? If your plan (or state law) provides for assets to be distributed per capita (“by the head”), they will go to the surviving child, potentially disinheriting your grandchildren. In contrast, if assets are distributed per stirpes (“by the branch”), then half will go to your surviving child and the other half will go to the deceased child’s family.

Harvest your portfolio’s gains or losses

Before year end, assess your investment portfolio and implement year-end investment strategies that can potentially minimize your tax bill. A tried-and-true strategy is harvesting gains or losses. Keep in mind that although the value of various investments may rise or fall during the year, these gains and losses exist only on paper and are not “realized” until you sell.

If you have realized net capital gains for the year, they will be taxed at rates as high as 20% for long-term gains and 37% for short-term gains. You also might owe state income tax and the 3.8% net investment income tax. To avoid this tax bite, consider “harvesting” available capital losses by selling investments that have declined in value and using the losses to offset your gains — but beware of the “wash sale rule.”

For more information, contact Rob Swenson at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Tax Services.Sign up here to receive our blogs, newsletters and Client Alerts.