A federal tax rule, Section 1202 of the Internal Revenue Code, allows the owners of certain C corporations to pay reduced or no federal income taxes on the gain from selling their stock. Stock that meets the rule is called qualified small business stock, or QSBS.
Why is this relevant to business owners?
If you own a growing company, or expect to start one, the gap between qualifying and not qualifying can be measured in millions of dollars. Most of what decides the outcome happens years before a sale: how the company is organized, how the stock was issued, and how long it has been held.
What is it worth?
Up to 100% of the gain on a sale of stock of a C Corporation can be excluded from the 20% federal capital gain tax, up to the greater of $15 million or 10 times what you paid for the stock, per owner, per company. The excluded gain may also escape the 3.8% Net Investment Income Tax.
How it works, in plain English
When you sell corporate stock for more than you paid for it, the difference is a “realized capital gain.” For stock held more than a year, the top federal tax rate is 20%, plus a 3.8% Net Investment Income Tax (or “NIIT”), for a combined 23.8% federal tax on long- term capital gain. Section 1202 allows an owner who is not a C corporation (e.g., an individual, a trust, or an estate) to shield some or all of that gain from federal taxation.2 Stock held by the foregoing through a partnership, an S corporation, or an LLC taxed as either can also qualify, but the exclusion applies to that entity’s owners, and only to those owners who held their interests when the entity acquired the stock and at all times after.
Below are core (not all) requirements. Stock buybacks by the company around the time of an issuance can also disqualify stock, subject to exceptions; Phase 3 covers those.
The company must be a domestic C corporation, and it must stay a C corporation for substantially all of the time you hold the stock.
A C corporation is a corporation that pays its own federal income tax, separately from its owners. S corporations, partnerships, and LLCs taxed as partnerships or S corporations are passthroughs that do not pay their own tax and are not able to issue QSBS. An LLC that elects to be taxed as a C corporation can issue QSBS. Important point: Even if your business is not currently operated as a C corporation, there may be ways to restructure into a C corporation that is able to issue QSBS, but revoking an S election does not turn existing shares into QSBS. The company must issue new stock after it becomes a C corporation, and the holding period for that stock starts then.3
Click to read entire insight: Qualified small business stock
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