By Kevin Kerrigan
The relatively unknown Qualified Small Business Stock (QSBS) capital gains exclusion was permanently extended in December 2015, giving many investors and entrepreneurs much reason to celebrate. While the QSBS tax break has been around since early 2009, the 2015 permanent extension incentivizes small business investors to look more closely at the QSBS.
Here are some of the advantages, conditions and drawbacks of QSBS.
Overview of the QSBS
The QSBS tax incentive was established to offer investment incentives to smaller companies, defined as C Corporations, holding less than $50 million in aggregate gross assets when the stock was issued. When it was first launched, QSBS offered a 50 percent exclusion of capital gains from the sales of an investment in a qualifying company. That amount later increased to a 75 percent exclusion and finally a full 100 percent exclusion but with a sundown date on the exclusion level. On December 18, 2015, the 100 percent exclusion was made permanent in Section 1202 of the Internal Revenue Code with the passage of the Protecting Americans from Tax Hikes (PATH) Act of 2015.
Tax benefits for investors
For qualified small business investors, the biggest benefit of a QSBS is clear: A zero percent effective income tax rate on qualifying capital gains. In addition, the gains are not subject to the federal Alternative Minimum Tax (AMT) or the 3.8 percent tax on higher earners to help fund the Affordable Care Act.
Requirements for investors under the QSBS include:
- Only individuals can take advantage of the tax benefit. A partnership can hold the QSBS stock and pass the gain eligible for exclusion to the individual partners.
- QSBS stock must be held a minimum of five years.
- The 100 percent capital gains exclusion rate is only good for stock purchases made after Sept. 27, 2010, when that rate was first temporarily put into effect. Stock purchased when the rate was at 50 percent or 75 percent capital gains exclusion levels will continue to yield those lesser amounts.
- The capital gains exclusion applies to the first $10 million of investment, or 10 times the taxpayer’s adjusted basis in the stock, whichever is greater. Any profits over that threshold will not earn the exclusion.
Prospective investors should keep in mind that some U.S. states follow federal guidelines when it comes to taxing QSBS-eligible investments, but others don’t. Ask your tax advisor how such an investment could impact your state filings.
QSBS-eligible companies and drawbacks
It stands to reason that any tax act that encourages individuals to invest in your company and others like it can only be beneficial. That said, there are certain limitations and conditions that will impact whether a corporation can be QSBS eligible.
To begin with, the act wasn’t written for all types of companies. Eligible corporations include those in the tech sector, as well as manufacturing, retail and wholesale companies. The list of ineligible business categories includes financial sector businesses (insurance, banking, financial services, etc.), farming, service businesses, health services and other types of service businesses.
In addition, only domestic C Corporations are eligible. That means that when investors wish to sell their company, it must be a stock sale rather than an asset sale. This can create challenges for buyers, who often would rather acquire assets to get higher depreciation and amortization deductions along with avoiding assuming liabilities. An asset sale by a C Corporation could result in taxes due near 60% after the liquidation of the corporation. So discuss all possible ramifications with your tax advisor to plan an exit strategy before setting up your business and choosing the QSBS corporation to take advantage of this tax code benefit.
Whether you are an investor on the hunt for a tax windfall or a small business owner looking for a capital infusion, QSBS tax incentives provide attractive tax benefits. Because it is a complex matter, consult your accountant or tax advisor to determine whether the QSBS capital gains exclusion is right for you.
Kevin Kerrigan, CPA of Wiss & Company LLP specializes in tax planning for high-net-worth individuals and family-owned companies. Reach Kevin at 973.994.9400 or firstname.lastname@example.org