Qualified Small Business Stock Planning
Internal Revenue Code Section 1202 permits business owners to exclude up to 100% of capital gains realized upon sale of “qualified small business” (QSB) stock held for more than 5 years.
The QSB stock exclusion is limited to “eligible gains” per issuer, equal to the greater of:
- $10 million lifetime limit or balance, thereof, or
- 10 times the adjusted basis (as of the original issue date) of the QSB stock disposed of during the year.
There is the possibility of receiving more than the $10 million lifetime limit. The ten times adjusted basis can be timed so you get the benefit of the ten times the adjusted basis and the $10mm lifetime limit. For example, you can use the $10 million lifetime limit in 2022 and assuming your adjusted basis is $3mm, the ten times adjusted basis in 2023 amount would be $30mm for a total benefit of $40mm over the two year period.
Significant Business Planning Opportunity
An often ignored and under-utilized planning opportunity exists under IRS code 1202 to exclude a significant amount of eligible gain from the sale or exchange of certain mid-sized business investments. The business must meet certain qualifications in order for the non-corporate investor to take advantage of the gain exclusion. The business should ideally be a C corporation, cannot initially have aggregate gross assets that exceed $50 million, and must be considered an active business. Specific businesses are excluded from the definition of a qualifying business.
The excluded amount of gain can be significant. The exclusion cannot exceed the greater of $10 million, reduced by prior gains attributable to the same issuer, or 10 times the aggregate adjusted basis of the investment issued by the corporation and disposed of by the investor during the year. Planning opportunities exist if you sell the investment in separate transactions over multiple years. In order for the exclusion to qualify, the investment must be an original issue and held for a specific minimum length of time. If you’re considering investing in a mid-sized business, Cendrowski Corporate Advisors can help you make the most of this planning opportunity.
To qualify as QSB stock, the stock must be ”original issue” stock of a “C corporation” that meets certain asset tests upon formation and for substantially all of the shareholder’s holding period and the company must be engaged in a qualified trade or business.
To meet the original issuance requirement, the QSB stock must be acquired at “original issuance,” meaning acquired directly from the corporation in exchange for money or other property (not including stock) or as compensation for services (other than underwriting) to the corporation. Original issue can include QSB stock acquired by gift or inheritance but does not include QSB stock purchased from an existing shareholder.
On the date the C corporation issues the stock, it must meet the qualified small business requirement by satisfying the aggregate gross assets test. This requires that the corporation’s gross assets cannot exceed $50 million as of date of issuance (or any time before) and immediately after the date of issuance, including assets received in the issuance. In testing the $50 million limit, all corporations that are members of the same parent-subsidiary controlled group (50% ownership) are treated as one corporation.
During substantially all of the shareholder’s holding period, the corporation must meet the active business requirement, whereby at least 80% of the assets (based on value) of the corporation must be used by the corporation in the active conduct of one or more “qualified trades or businesses” (QTB).
Assets used for start-up activities including R&D or held for working capital needs are included as assets used in the active conduct of a qualified trade or business for the 80% test.
Tax Strategy and Planning for Qualified Small Business Stock
Cendrowski Corporate Advisors provides personalized, tax-efficient strategies for investors and business entities. Our qualified team works to develop responsive solutions to strategic business and investment decisions that allow for seamless exit and transition strategies. One such strategy our team is experienced with is planning with Qualified Small Business Stock (QSBS) under Internal Revenue Code Section 1202 (aka 1202 Stock).
Whether it is entity structuring planning, business transactional planning, succession planning or estate planning, our qualified team considers the merits of qualifying as QSBS as part of the planning process. If the business meets certain qualifications under Section 1202 for QSBS, non-corporate investors who hold on to the stock for at least five years, can exclude 100% of their gain (subject to certain limitations) on disposition of the stock, or of the business. Planning opportunities also exist for investors who dispose of the QSBS before the minimum five-year holding period if such proceeds are reinvested into another qualifying business. CCA's team members are well-versed in the intricacies of QSBS, the associated documentation and the specific steps, tailored for each client scenario, to meet the requirements under Section 1202. We have a unique array of experience and offer a "different perspective" to our clients.
Client Success: Utilization of QSBS provisions under Section 1202.
We were engaged to review the existing structure and tax planning for a business conglomerate. The empire of companies, as well as each company, had its own financial executives and multiple third party advisors, from each facet of the business: legal, accounting, financing, etc.
Although well supported with experienced advisors, we were able to identify a couple of planning opportunities that had not been in place, one of which was utilization of the QSBS provisions under Section 1202. We worked closely with the team of other legal and financial advisors, as well as key company personnel, to become familiar with the business and the entity and ownership structures, as well as the tax and financial positions, and were able to identify specific entities to focus on at a deeper level that may benefit from QSBS status.
After performing after-tax cash flow projections delineating the tax savings and benefit of qualifying as a QSBS, we worked as a team to gather the pertinent information and documents to determine whether certain requirements were met and made recommendations where such requirements were not met in order to satisfy Section 1202. We also carefully reviewed the impact on other tax and financial issues in order to make the appropriate overall recommendations.
The client now has a recommended advisory committee, with whom we have provided a detailed road map for 1202 qualification throughout the company lifespan in order to maintain the QSBS status and realize the up to $15 million projected tax savings to either the controlling family interests and/or various third party investor interests.