How Can You Benefit From Investing in Qualified Small Business Stock?

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By Matt Mormino, CFP®

If you invest in a local enterprise, family-owned firm, or small business, you can access significant tax benefits by purchasing shares of qualified small business stock (QSBS). The Internal Revenue Code (IRC) of the IRS categorizes a qualified small business (QSB) as a currently active domestic C corporation with gross assets of less than $50 million.

Understanding the conditions of investing in QSBS under Section 1202 of the IRC can help you plan appropriately when adding these securities to your portfolio. Individuals can exclude capital gains of up to $10 million or ten times the cost basis of the stock from their income tax for the year in which they sell QSB shares.

QSB Eligibility

Shares purchased from a QSB after August 10, 1993 are considered qualified small business stock. Only businesses in specific industries, including manufacturing, wholesale, retail, and technology, qualify as QSB. The IRS does not recognize mining, farming, financial, personal services, or hospitality businesses in this category. In addition, the corporation that issued the stock must use at least 80 percent of its assets to directly support business operations.

Tax treatment of QSBS

Generally, you do not have to pay federal income tax on capital gains associated with QSBS, although some limits apply. If you purchased shares in a QSB after September 27, 2010, QSBS income is exempt from capital gains tax under the Protecting American From Tax Hikes (PATH) Act. The maximum for this exemption is the greater of ten times the stock’s adjusted basis or $10 million.

You can exclude 75 percent of capital gains for shares purchased from February 18, 2009 to September 27, 2010, and 50 percent for QSBS acquired from August 11, 1993 to February 17, 2009. However, in both cases, you must pay alternative minimum tax (AMT) on 7 percent of the exempted amount.

Investor qualifications for QSBS

Only certain investors can receive advantageous QSBS tax treatment. Qualifying investors must buy the stock upon issue and not from a secondary source. They must have provided property, cash, or a service in exchange for the shares in question and held them for at least five years. Corporate investors cannot claim the QSBS tax benefit.

Planning for QSBS investments

Careful preparation can give you full access to QSBS tax advantages by maximizing your capital gains exclusion. First, it’s important to understand that the cap of either $10 million or ten times the stock’s value applies to each taxpayer and QSB. For example, if you have QSBS shares from more than one company, the exclusion cap applies to each QSB. By the same token, if you and your spouse both hold shares in the same QSB, the total cap for both of you is $20 million or 20 times the original value of the shares.

You must also understand how to calculate the 10x basis (stock value) cap, which applies to the original purchase price of QSBS shares. For example, if you purchased $2 million in QSB securities, the basis cap is $20 million regardless of how the shares have changed in value since the original transaction.

The exclusion amount for each taxpayer and QSB applies to the specific tax year only. In other words, when you sell QSBS, you can take the full exclusion in that tax year. A remainder will not carry over to subsequent tax years if you do not reach the exclusion cap.

With these background details in hand, consider the following strategies to increase your available capital gains exclusion for QSBS.

Distribute QSBS benefits

When you share your QSBS with other taxpayers, you can each use the 10x basis or $10 million exclusion cap. To utilize this strategy, purchase QSBS along with other taxpayers, such as family members or adult children. Each person can take advantage of the tax benefits. You can also purchase QSB shares through an S corporation, LLC, limited partnership, or non-grantor trust.

Double-check the holding period

If you sell QSBS before the five-year mark, you forfeit your ability to exclude capital gains. For this reason, investors should understand when the five-year holding period begins for different types of securities:

  • Purchase date – Standard stock
  • 83(b) election or vesting date – Restricted stock or restricted stock units (RSUs)
  • Exercise date – Stock option or warrant
  • Conversion date – Convertible debt

Selling QSBS early, even by just a few days, can dramatically increase your tax burden.

Transfer QSBS to a non-grantor trust

When you establish a non-grantor trust, you can transfer ownership of QSBS to the trust. After doing so, you can qualify for the full exclusion as an individual taxpayer, and the trust qualifies for a separate $10 million exclusion when you sell the transferred shares. Many taxpayers use this strategy to create a trust that will benefit future generations, including children and grandchildren.

Gift QSBS to others

If you plan to provide for loved ones in your estate plan, consider gifting QSB shares to these individuals during your lifetime. You can make tax-free gifts of up to $15,000 per individual in 2021, with a lifetime gift tax exemption of $11.7 million. The IRS taxes gifts above these limits at 18 to 40 percent depending on the recipient’s tax bracket. Note: many states do not assess taxes on gifts, and lifetime gifts in these states can be part of an effective strategy to avoid estate tax at the state level.

With these planning strategies in mind, you can effectively reduce your taxable income when incurring capital gains related to qualified small business stock.

Matt Mormino, CFP® is an advisor at Brighton Jones.

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