Qualified small business stock exclusion

In short

If you are a founder, you have probably heard someone say the tax bill on selling your company can be wiped away. A friend of mine heard that at a dinner and went home thinking it was automatic. It is not. Section 1202 of the Internal Revenue Code lets a seller leave out part or all of the gain on qualified small business stock, but only when the stock, the company, and the holding time all meet the rules. The cap on the leave out amount is set by law, and Section 1202 of the Internal Revenue Code is where it is found. Write down the date you got your shares, since that date decides which percentage applies. Check each test against the company's records before any sale talk gets serious. Then bring the facts to a tax professional, who can see your full return.

The whole of it

What it is

I once sat with a founder who had spent nine years building a small machine shop into something a buyer wanted. He asked me whether the government really lets people keep some of that gain tax free. The answer is yes, in a narrow lane, and he took heart from that.

Qualified small business stock, often shortened to QSBS, is stock in a certain kind of United States company. It is covered by Section 1202 of the Internal Revenue Code. When a seller meets every test, part or all of the gain from selling that stock can be left out of federal income. Left out means the seller does not pay regular federal income tax on that slice of the gain.

The law was written to help young companies raise money. Investors and founders who put cash into a small business and stay with it for years get a reward when they sell. That is the whole idea.

Stock does not qualify just because it is stock in a small company. Several tests have to be passed at once, and each one is a place where a good plan can slip. The company must be a C corporation, which is a company taxed on its own, apart from its owners. The stock must be new, meaning the seller got it straight from the company, usually for cash, property, or work done. It cannot be bought later from another shareholder in most cases.

How it works

You have probably wondered where the test for the size of the company comes in. The company must have gross assets of no more than a set amount at the time the stock is issued and right after. That set amount is the current figure, which the official source publishes each year. Gross assets means the cash and the adjusted tax cost of the other things the company owns.

The company must also be in an active business. At least a set share of its assets has to be used to run that business. Some fields are left out by the statute, including health, law, engineering, banking, farming, and hotels or restaurants. Check the list in the statute itself, since it decides who gets in.

Then there is the holding time. The stock must be held for a minimum number of years, which is the current figure, which the official source publishes each year. For stock issued after a certain date, the law lets a smaller share of the gain be left out after a shorter hold. The share left out can be the current figure, which the official source publishes each year, depending on when the stock was issued and how long it was held. The date of issue matters a great deal.

The Internal Revenue Service describes the reporting steps in the instructions for Form 8949 and Schedule D. A seller reports the sale there and marks the amount being left out. The company is also asked to keep records showing it met the tests.

One more point. The leave out has a cap for each issuing company. The cap is the greater of two things, a flat dollar amount or a multiple of the seller's cost in the stock. The flat amount is the current figure, which the official source publishes each year. The multiple is the current figure, which the official source publishes each year. Both are set by law, so read the current figure on the official page before counting on it.

The numbers, and where to find yours

A neighbor of mine once spent a whole weekend hunting for one date. It was the day his shares were issued, and he found it in a stock ledger he had forgotten about. That single date told him which rules applied.

Your numbers live in a few places. The issue date and the number of shares are on your stock certificate or in the company's stock ledger. Your cost in the stock, which the tax code calls basis, is what you paid, or the value of what you gave the company for the shares. The company's gross assets on the issue date come from its balance sheet at that time. The company's finance records or its law firm can usually pull these up.

The percentage you may leave out is tied to the issue date. The official source is Section 1202 of the Internal Revenue Code, and the Internal Revenue Service publishes the form instructions that apply to the sale. Do not guess the tier. Match your date to the table on the official page.

Keep copies of everything. If the Internal Revenue Service ever asks, the seller has to show the stock qualified. A missing paper can undo a good result.

A worked example

Let me tell you about Maria, a founder I will make up for this page. She started a software company, and the company issued her 100,000 shares for work and a small cash payment. Her cost in the stock was $40,000. The company was a C corporation, and its gross assets were well under the limit on the day her shares were issued.

Maria held her shares for six years. Then a buyer paid $1,040,000 for them. Her gain is the sale price minus her cost. That is $1,040,000 minus $40,000, which is $1,000,000.

Suppose, for this story, that her issue date put her in the tier that lets 100 percent of the gain be left out, and the company met every test. Her left out gain would be 100 percent of $1,000,000, which is $1,000,000. The taxable gain from the exclusion would be $0 on that amount.

Now check the cap. Say, for the story, that the flat cap were $10,000,000. Ten times her cost would be 10 times $40,000, which is $400,000. The greater of the two is $10,000,000. Her $1,000,000 gain sits well below that, so the cap does not bite.

Compare that with a sale that does not qualify. If the same $1,000,000 gain were taxed at a long term capital gains rate of 20 percent, the federal tax would be 20 percent of $1,000,000, which is $200,000. These figures are Maria's story and nothing more. Your own rates, state rules, and extra taxes will differ.

Where it goes wrong

I have watched good plans fall apart over small things. The trouble is rarely the big idea. It is the date, the form, or the label on the company.

The first slip is entity type. If the company was an LLC taxed as a partnership when the stock was issued, the stock did not come from a C corporation, and it will not qualify. A later switch to a C corporation does not rewrite the past.

The second slip is buying shares from another holder. Stock bought on a secondary sale generally does not count, since the stock must come from the company itself. Section 1202(h) of the Internal Revenue Code sets special rules for some transfers, such as shares passed on at death, and the facts of each case decide how they apply.

The third slip is the holding time. Selling a month early can change the tier, or cost the whole benefit. The fourth is the business type, since the statute lists fields that are shut out. The fifth is the asset test, because the company can lose its status if it holds too much in assets that are not used in the business.

Finally, states differ. Some states follow the federal leave out and some do not. A seller may owe state tax even when the federal tax is zero. Read your state's rules, and do not assume.

Questions to answer before you leave this page

Do you know the exact day your shares were issued, and can you find it in a written record? Was the company a C corporation on that day, and did it stay one through the sale? Did the shares come from the company itself, or did you buy them from someone else? Were the company's gross assets under the legal limit when the stock was issued? Does the business fall into one of the fields the statute shuts out? Have you held the shares long enough to reach the tier you are counting on? Does your state follow the federal rule? And who will you ask to review all of this before you sign anything?