Building a business is a challenging endeavor. Therefore, you want to maximize the value you create with your business for you and your shareholders. A great way to do that, if you qualify, is through Qualified Small Business Stock or QSBS, which we define below.
The Definition of “Qualified Small Business” and Associated Stock (QSBS)
Section 1202 of the Internal Revenue Code (IRC) deals with QSBS. The law makes it possible for your shareholders to reap all of the gains of your growing company at lower tax rates or tax-free, if your company meets the definition of a qualified small business.
The main conditions to qualify as a Qualified Small Business
- Your company must be a U.S.-based C corporation. S corporations do not qualify.
- It must be an active business and not a holding company.
- Your business assets cannot exceed $50 million at any point after August 9, 1993. This applies both before and after you issue the stock.
- You cannot be in a business that offers personal services, such as operating a hotel, motel, or restaurant, banking, insurance, leasing, financing, investing, mining, or farming. Qualifying businesses include retailing, wholesaling, technology, and manufacturing.
- The stock has to be acquired in exchange for money or property, or as payment for services provided to your business. Stock transferred from one individual to another does not usually qualify for the tax break.
- Both your company and the shareholder have to agree to provide certain documentation in relation to the stock.
- While those are the major requirements, it is not an exhaustive list. You must consult a knowledgeable tax advisor to determine if your specific corporation’s stock is eligible under Section 1202.
What are the Tax Benefits of Qualified Small Business Stock?
Instead of the usual capital gains taxes, some QSBS is subject to lower tax rates or even exempt from taxation. How your QSBS is taxed will depend on when it was acquired by the shareholder and how long it was held. The greatest benefits come from holding the stock for at least five years.
There are three different time periods for acquisition:
- Stock Acquired Before February 18, 2009: No more than 50% of the gain can be excluded from taxation. In addition, 7% of the gain is subject to the alternative minimum tax (AMT).
- Stock Acquired Between February 18, 2009, And September 27, 2010: As with shares acquired earlier, 7% of the gain is subject to the AMT. However, 75% of the gain can be excluded from taxable income.
- Stock Acquired After September 27, 2010: When held for more than five years, this stock’s gain is completely tax-free. It is not subject to income tax, AMT, or even the 3.8% net investment income tax. If the stock is held between one and five years, then the gain is just a normal capital gain and taxed at those rates. The gain is a short-term capital gain taxed as ordinary income when the stock is held for less than one year.
There is a limit to the tax benefit your shareholders can receive, though. The excludable gain cannot be more than the greater of $10 million or 10 times the adjusted basis of the investment. If the stock is held between six months and five years, it can be sold and reinvested in another qualified small business within 60 days without triggering taxes due.
How Can Business Owners Use Qualified Small Business Stock?
With the potential of completely tax-free gains, QSBS is a powerful tool. If you’re looking to raise capital, reach out to individuals and partnerships, since corporations do not receive any tax benefits from QSBS. Explain to your investors how the tax benefits work so that they understand the true value of your company’s stock.
Everyone wants to get in on the ground floor of a company like Google or Twitter, and your company may be the next big success. If you compensate your employees with stock, not only does it protect your precious cash flow, but they have the potential to reap all of their rewards tax-free. It will also motivate your employees to stay and work hard, as their financial gains are tied directly to the success of your company.
A Potential Risk: Payroll Taxes
If you issue QSBS without restrictions, the value of the stock is taxable compensation to the employee. As such, you will have to pay payroll taxes and withhold income taxes as if you had paid the employee in cash instead of stock. Withholdings must be paid in cash, not equity. They can be calculated by adding the value of the stock to the regular salary and figuring the withholding as usual. Also, a flat 22% of the value of the stock can be withheld, going up to 37% when the value exceeds $1 million.
Harness Wealth can pair you with the advisory firms you need to provide advice across your financial, tax, and legal concerns for your equity. To identify the right advisory firms for you, get started here.