Investors holding qualified small business stock (QSBS) may be confused about what the tax rules are but they should know that they can qualify for tax benefits. This can encourage small business investment while providing a benefit for investors. There are some small business and shareholder rules that you must follow in order to qualify. Read on to learn more or you could speak with a financial advisor who can help you through situations like these and properly plan out your taxes.
What Is Qualified Small Business Stock (QSBS)?
Qualified small business stock (QSBS) is stock that is eligible for the special tax rules created by Section 1202 of the Internal Revenue Code (IRC). Under this section of the tax code, eligible shareholders are permitted to exclude some or all the capital gains on QSBS. Generally, this exemption allows eligible shareholders to write off at least half of the capital gains tax on their shares.
This exemption was introduced to encourage investment in small businesses. In the United States, small businesses are a vital part of the economy. However, investing in these businesses can be risky. To incentivize small business investment, the IRS introduced this tax exemption as part of the Revenue Reconciliation Act of 1993. In 2010, the Small Business Jobs Act expanded the exemption.
QSBS Tax Rules
The QSBS tax exemption allows small business owners to potentially save a significant amount on capital gains. In general, investors can deduct up to $10 million in taxes or 10 times the adjusted cost basis, whichever is greater. Any earnings above that amount are taxed at the ordinary capital gains rate. To qualify for the exemption, investors must hold their shares for at least five years.
The amount of the exemption depends on the date of the stock purchase. For stocks purchased between the 1993 bill and February 18, 2009, the maximum exemption is 50%. In this scenario, 7% of the capital gain is subject to alternative minimum tax (AMT).
For stocks purchased between February 18, 2009, and September 27, 2010, the maximum exemption is 75%. 7% of the capital gain is subject to AMT. And, finally, for all stocks purchased after September 27, 2010, investors can deduct 100% of capital gains up to $10 million.
Small Business Requirements
Not all companies qualify as small businesses under IRS rules. For company shares to be eligible for the tax exemption, all the following requirements must be met:
- Assets must not exceed $50 million: This requirement applies both before and after the company issues stock.
- Must be an active C-corp: The company must be an active C-corporation that is incorporated in the United States.
- Must operate in an eligible industry: Not all industries are eligible for this exemption. Eligible industries include technology, retail, manufacturing and wholesale. Excluded industries include banking, finance, insurance, farming, mining and hospitality-related industries.
While these are the rules that currently apply, they aren’t guaranteed forever. For instance, if a small business grows enough that its assets surpass $50 million, its stock would no longer be eligible. Another possibility is one in which the law changes. Up till now, the law has only become more generous to investors. But this doesn’t eliminate the possibility of a future law change which would make things less favorable for small business investors.
There are some requirements shareholders must meet to be eligible for this tax exemption, regardless of whether the small business qualifies. These requirements for investors are:
- Cannot be a corporation: While the entity in which you invest must be a corporation, the investor cannot also be a corporation. The investor should be an individual, trust or pass-through entity.
- Must hold stock in the company: This exemption is limited to stocks. It doesn’t apply to bonds, options or other types of assets.
- Hold for at least five years: You generally must hold your shares for at least five years before you qualify for this exemption.
The Bottom Line
Qualified small business stock (QSBS) is stock in a small business that may qualify for a tax exemption. This exemption was originally introduced in 1993 and has since been expanded to let investors exempt up to 100% of capital gains tax on their QSBS. Investors can eliminate taxes on up to $10 million of capital gains or 10 times the adjusted cost basis, whichever is greater. After that, capital gains are taxed at the ordinary rate. This exemption can grant significant tax savings for those willing to invest in budding small businesses.
Tips for Investing
- Deciding how to allocate your portfolio isn’t always easy. However, a financial advisor can help you make the right choice. A financial advisor can help you figure out and put together a strategy to help you reach your goals. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Unsure how much your investments will grow over time? Try SmartAsset’s free investment calculator to estimate how much you will have in 10, 15 or 20 years. Whatever your time horizon might be, it’s important to know where you stand.
Photo credit: ©iStock.com/Hispanolistic, ©iStock.com/Vladimir Vladimirov, ©iStock.com/Dan Rentea