There are a lot of opportunities to accelerate wealth-building, most of them focused on optimizing profit while minimizing costs such as operating expenses and more importantly, taxes. On the plus side, there are existing systems that allow you to meet both criteria, and one of them is qualified small business stock (QSBS).
QSBS refers to stocks or shares from a qualified small business that, when sold to other entities, is incentivized by the government in the form of tax breaks and reports. Not only does it allow shareholders the means to keep more of their income for themselves, but it also supports small businesses trying to raise the capital they need in order to take the next step in their endeavor.
Whether you’re a qualified small business owner looking to issue these stocks or an entity looking to purchase them, here’s how QSBS can help you and your businesses.
While QSBS sounds like a lucrative opportunity for tax breaks and increased income, there are certain criteria that must be met, both for the small business that will offer the qualified stocks and the entities looking to purchase them.
The Internal Revenue Code defines the domestic portion of taxes as applied in the United States. It contains Section 1202, which defines capital gains from small business stocks and which of them can be excluded from federal tax. It was enacted to encourage people who are starting a business as well as to support these entities by incentivizing the purchase of stocks.
However, a small business stock is only considered qualified if it meets the following criteria:
- It was issued by a domestic C-corporation business entity. Furthermore, the issuing business should not be a firm in the fields of law, engineering, architecture, finance, real estate, agriculture (farming), mining, as well as hotels and restaurants.
- The stocks must be originally issued after August 10, 1993 (when Section 1202 was first enacted) in exchange for money or assets excluding stocks, or as compensation for services rendered to the issuing entity.
- The issuing entity should have assets not exceeding $50 million on the day that the stocks were issued.
- Additionally, at least 80% of the issuing entity must be used for the active implementation of its declared qualified businesses.
- Lastly, the issuing party should not “significantly redeem” its own stock for a period of two years starting the issuance date. This refers to a redemption effort by the company–or buying back its own shares–that exceeds 5% of the total value of the small business’s stocks.
On the other hand, buyers of QSBS qualify for its tax benefits as long as the following criteria are met:
- Direct acquisition. The QSBS in question must be acquired by the current holder directly from the issuing party. If it was obtained through a middleman or another intermediary, it is automatically disqualified.
- No corporations. Eligible stockholders should not be corporations; they could be individuals, trusts, or qualified pass-through or flow-through entities.
- Holding period. The shareholder must own the QSBS for more than five years, with the count starting the day after the shares were transferred.
Aside from expressing support for a small business of your choice, one of the main reasons why QSBS remains a popular investment choice is that its capital gains are generally exempted from federal taxes. This means that when you sell your qualified small business stocks, you can be exempted from the taxes coming from this sale. The exempted capital gains are up to $10 million or ten times the basis of the initial investment made, whichever of the two is greater in value. The latter also covers the fair market value of assets contributed to the qualified small business in exchange for stock.
However, the benefits of QSBS do not end there. For starters, the tax breaks can be “rolled over” or transferred to another QSB. Also known as a 1045 rollover, the provisions of the IRC Section 1045 allow QSBS holders to transfer their stocks to a replacement qualified small business. This instance was originally designed to allow shareholders in companies that were sold, acquired, or was turned over before the five-year holding period.
Not only does it save a missed opportunity for cashing in a valuable QSBS selling opportunity and its associated tax breaks. By ensuring that the provisions of the IRC Section 1045, business wonders can ensure that the taxes are deferred until the stocks in the replacement qualified small business has been sold.
Even better is that tax breaks from QSBS can be multiplied through a number of other legal options. One example is the so-called Trust Stacking. Essentially, if you gift, transfer, or bequeath your QSBS to a qualified trust fund, the beneficiaries of the QSBS will enjoy its tax breaks plus those of the trust. This multiplies the capping limit to the tax-exempted value and potentially allows the beneficiaries to pay fewer taxes and keep more income for themselves.
A qualified small business stock, like any other share of equity, carries a set of risks inherent to it. However, the efforts of the government to incentivize support for small business owners have resulted in legally allowable systems and structures that can prove beneficial to all parties holding them–whether it be the small business owner or the investors and shareholders who provided support in the form of stocks.