PARTNER CONTENT

By George Teixeira, CPA, MST Tax Partner, Anchin

The Qualified Small Business Stock (QSBS) Exclusion, a vital provision for founders, investors, and employees of small businesses, offers a significant tax advantage by exempting capital gains tax on qualifying stock. This exemption is available to each qualifying shareholder of each corporation from which qualifying stock is held.  The provision affords an exclusion of up to 100% of the gain on the sale of QSBS which is capped at the greater of $10 million or 10x the basis of shareholder stock so long as the stock was held for at least five years before the sale, it can potentially save millions in federal taxes, with opportunities to further enhance the benefit in conforming states. However, both corporations and shareholders must meet specific criteria to qualify, highlighting the importance of understanding and maintaining QSBS eligibility. Understanding QSBS eligibility requirements

To qualify for QSBS, both the corporation and shareholders must adhere to strict eligibility requirements. The corporate criteria include:

• Entity structure: The corporation must be a domestic C corporation.
• Reporting obligations: The corporation must agree to provide necessary reports to the IRS and shareholders confirming the eligibility requirements of the entity and originally issued stock to shareholders.
• Stock issuance: The qualifying stock must be originally issued by the corporation, limiting shareholder transfers.
• Active business requirement: At least 80% of the business’ assets must be used in the conduct of a qualifying business. Ownership stakes in other companies are also considered, with less than majority ownership deemed passive. Exceptions exist for cash as working capital and for startup and technology companies.
• Aggregate gross assets: Historical and current assets value must not have surpassed a $50 million threshold. For this test, the assets are measured as cash plus the basis of all property held by the corporation.  

Phases of QSBS analysis: Creation and protection

QSBS analysis involves two interdependent phases: Creation and Protection. Establishing qualification is crucial, but equally important is the ongoing preservation of QSBS status to ensure subsequent shares qualify and existing shares retain their tax-exempt status. Unwitting actions can disqualify shares, making vigilant maintenance akin to preserving valuable assets like jewelry or art.

Corporate QSBS eligibility protection

A corporation's loss of QSBS status can affect the stock in several ways:

• Previously issued shares: These can lose their eligibility, a common issue during the startup phase due to excessive stock redemption.
• New shares: New shares may become ineligible while previously issued shares retain their status.
• Exclusion of further gain: Existing shares may lose the ability to exclude future gains, although any existing gain as of the status change date would still qualify for exclusion.

Prudent structuring of acquisitions can help maintain QSBS eligibility, particularly when evaluating majority versus minority interests in another entity.

Transactions and QSBS: Maximizing opportunities

For optimal QSBS benefits, involving tax advisors from the inception of the entity is ideal. Complex entity structures without initial QSBS advisory make it challenging to maintain QSBS benefits during day-to-day operations, potentially reducing perceived value to investors expecting a tax-free exit.  Key transaction considerations

• Mergers and acquisitions: Ensure that transaction steps do not invalidate stock qualification.
• Business inception or asset acquisition: Evaluate impacts on the 80% active business requirement.
• Stock vs asset acquisitions: Determine which scenario is ideal for maintaining QSBS eligibility.
• Convertible instruments: Evaluate QSBS qualification at the time of conversion, not issuance.
• Financing rounds: Ensure investments qualify and address any $50 million threshold issues.
• Stock redemptions: Avoid disqualifying the entity or shareholder stock.
• Pass-through entities: Consider distribution of C corp stock to partners versus entity-level sales.
• Incubator and fund considerations: Plan for QSBS qualification and tax-free results for investors.

Operational considerations

• Approaching two-year mark: Monitor cash on hand.
• $50m aggregate threshold: Structure to avoid surpassing this limit.
• Research and experimentation: Monitor aggregate gross asset considerations.

Investor Considerations

• Stock transfers: Ensure stock is originally issued to the desired holder.
• Selling QSB stock before five years: Explore tax-free reinvestment options to preserve benefit
• Exceeding $10m profit: Opportunities for multiplying the exclusion exist and are often attractive to those also interested in exploring certain estate planning opportunities.

Navigating QSBS eligibility is complex but crucial for maximizing tax advantages. Engaging knowledgeable advisors ensures that both corporations and investors can strategically maintain QSBS status, preserving valuable tax exemptions and enhancing the overall investment value. 

For more information on the Qualified Small Business Stock (QSBS) exclusion and the tax savings opportunities it presents businesses, please reach out to George Teixeira, Tax Partner and Leader of Anchin’s Financial Services Practice or to learn more about Anchin visit us here.

George Teixeira, CPA, MST, Tax Partner, Anchin – George is the Tax Leader of the Firm’s Financial Services Practice and Leader of the Firm’s Private Equity Group, as well as a member of Anchin Private Client. George is experienced in servicing the alternative investment, private equity, and financial services industries. His expertise includes tax planning for high-net worth individuals, investment partnerships, investment advisors, broker-dealers, venture capital companies, hedge funds (and their investors), investment partnership management companies and general partner entities. He specializes in the taxation of securities transactions and financial services companies, in addition to offering tax compliance and consulting services for a diversity of entities and individuals. George works closely with clients to develop effective planning structures and strategies. He advises high-net-worth individuals on estate planning, trust planning, charitable contributions and investment strategy and planning. His specific knowledge of straddles, swaps, options, wash sales and mark to market investments has led to his involvement with some of the largest investment partnerships in the country and the expansion of investment firms’ funds offshore.