Qualified Small Business Stock (QSBS) & IRC 1202

Section 1202 Small Business Stock Capital Gains Exclusion

What is Qualified Small Business Stock (QSBS) Under IRC 1202: When it comes to investing in smaller companies, aside from trying to get as much bang for the buck with the Return on Investment (ROI) — US Taxpayers want to avoid or minimize taxation as much as possible. Aside from an 83(b) Election, for individual investors, there are not necessarily that many tools available that a Taxpayer can use in order to minimize tax on Capital Gain paid to the IRS.  If the capital gain is long-term, the taxpayer’s tax liability is usually limited to 15 or 20% — depending on the year and the tax bracket. There is one type of investment a Taxpayer can make in which they  may be able to eliminate most if not all of the gain — and that is the gain on the sale of Qualified Small Business Stock (QSBS) in accordance with Internal Revenue Code section 1202. Let’s take a look at how qualified small business stock (QSBS) works in conjunction with IRC 1202.

QSBS Definition Under IRC 1202

In order first stock to establish the elements to become a Qualified Small Business Stock (QSBS), the stock must meet the requirements of Internal Revenue Section (IRC) 1202. While there are many technical requirements for a business to meet the definition of a QSBS, here are main requirements:

(c) Qualified Small Business Stock

• • • For purposes of this section—

(1) In general

• • • Except as otherwise provided in this section, the term “qualified small business stock” means any stock in a C corporation which is originally issued after the date of the enactment of the Revenue Reconciliation Act of 1993, if—

    • (A) As of the date of issuance, such corporation is a qualified small business, and

    • (B) Except as provided in subsections (f) and (h), such stock is acquired by the taxpayer at its original issue (directly or through an underwriter)—

    • (i) in exchange for money or other property (not including stock), or

    • (ii) as compensation for services provided to such corporation (other than services performed as an underwriter of such stock).

(2) Active business requirement; etc.

• • • (A) In general

    • Stock in a corporation shall not be treated as qualified small business stock unless, during substantially all of the taxpayer’s holding period for such stock, such corporation meets the active business requirements of subsection (e) and such corporation is a C corporation.

(3) Certain Purchases by Corporation of its Own Stock

• • • (A) Redemptions from taxpayer or related person

    • Stock acquired by the taxpayer shall not be treated as qualified small business stock if, at any time during the 4-year period beginning on the date 2 years before the issuance of such stock, the corporation issuing such stock purchased (directly or indirectly) any of its stock from the taxpayer or from a person related (within the meaning of section 267(b) or 707(b)) to the taxpayer.

    • (B) Significant redemptions

    • Stock issued by a corporation shall not be treated as qualified business stock if, during the 2-year period beginning on the date 1 year before the issuance of such stock, such corporation made 1 or more purchases of its stock with an aggregate value (as of the time of the respective purchases) exceeding 5 percent of the aggregate value of all of its stock as of the beginning of such 2-year period.

    • (C) Treatment of certain transactions

    • If any transaction is treated under section 304(a) as a distribution in redemption of the stock of any corporation, for purposes of subparagraphs (A) and (B), such corporation shall be treated as purchasing an amount of its stock equal to the amount treated as such a distribution under section 304(a).

(d) Qualified Small Business

• • • For purposes of this section—

    • (1) In general The term “qualified small business” means any domestic corporation which is a C corporation if—

    • (A) the aggregate gross assets of such corporation (or any predecessor thereof) at all times on or after the date of the enactment of the Revenue Reconciliation Act of 1993 and before the issuance did not exceed $50,000,000,

    • (B) the aggregate gross assets of such corporation immediately after the issuance (determined by taking into account amounts received in the issuance) do not exceed $50,000,000, and

    • (C) such corporation agrees to submit such reports to the Secretary and to shareholders as the Secretary may require to carry out the purposes of this section.

(e) Active Business Requirement

• • • (1) In general

    • For purposes of subsection (c)(2), the requirements of this subsection are met by a corporation for any period if during such period—

    • (A) at least 80 percent (by value) of the assets of such corporation are used by such corporation in the active conduct of 1 or more qualified trades or businesses, and

    • (B) such corporation is an eligible corporation.

Important Takeaways from the QSBS Definition

Here are 3 important takeaways from the definition of a QSBS Under 1202:

Active Business

The business must be “active.” In other words, the business must be operating and technically conducting business —  this is distinct from a passive type of business such as a holding company or other type of inactive business the does not operate besides holding investments that generate income.

Asset Total

The total value of the corporations assets cannot exceed $50 million (some exceptions and limitations apply).

C Corporation

One of the primary requirements to be considered QSBS is that the company is a C Corporation and not an S Corporation. This is crucial, because many small businesses are actually S Corps and not C Corps. Thus, if a Corporation is considering becoming QSBS qualified — it should maintain C corporation status.

IRC 1202 and Claiming the Exclusion

When it comes to claiming the IRC 1202 exclusion, there are many requirements the Taxpayer must meet. Here are some the main requirements:

(a) Exclusion

• • • (1) In general In the case of a taxpayer other than a corporation, gross income shall not include 50 percent of any gain from the sale or exchange of qualified small business stock held for more than 5 years.

    • (2) Empowerment zone businesses

(A) In general

• • • In the case of qualified small business stock acquired after the date of the enactment of this paragraph in a corporation which is a qualified business entity (as defined in section 1397C(b)) during substantially all of the taxpayer’s holding period for such stock, paragraph (1) shall be applied by substituting “60 percent” for “50 percent”.

(B) Certain rules to apply

• • • Rules similar to the rules of paragraphs (5) and (7) of section 1400B(b) (as in effect before its repeal) shall apply for purposes of this paragraph.

(C) Gain after 2018 not qualified

• • • Subparagraph (A) shall not apply to gain attributable to periods after December 31, 2018.

(D) Treatment of DC zone

• • • The District of Columbia Enterprise Zone shall not be treated as an empowerment zone for purposes of this paragraph.

    • (3) Special rules for 2009 and certain periods in 2010

      • In the case of qualified small business stock acquired after the date of the enactment of this paragraph and on or before the date of the enactment of the Creating Small Business Jobs Act of 2010—

    • (A) paragraph (1) shall be applied by substituting “75 percent” for “50 percent”, and

    • (B)paragraph  (2) shall not apply.

      • In the case of any stock which would be described in the preceding sentence (but for this sentence), the acquisition date for purposes of this subsection shall be the first day on which such stock was held by the taxpayer determined after the application of section 1223.

    • (4) 100 percent exclusion for stock acquired during certain periods in 2010 and thereafter

    • In the case of qualified small business stock acquired after the date of the enactment of the Creating Small Business Jobs Act of 2010—

      • (A) paragraph (1) shall be applied by substituting “100 percent” for “50 percent”,

      • (B )paragraph (2) shall not apply, and

      • (C) paragraph (7) of section 57(a) shall not apply.

    • In the case of any stock which would be described in the preceding sentence (but for this sentence), the acquisition date for purposes of this subsection shall be the first day on which such stock was held by the taxpayer determined after the application of section 1223.

(b) Per-issuer limitation on taxpayer’s eligible gain

(1) In general

• • • If the taxpayer has eligible gain for the taxable year from 1 or more dispositions of stock issued by any corporation, the aggregate amount of such gain from dispositions of stock issued by such corporation which may be taken into account under subsection (a) for the taxable year shall not exceed the greater of—

    • (A) $10,000,000 reduced by the aggregate amount of eligible gain taken into account by the taxpayer under subsection (a) for prior taxable years and attributable to dispositions of stock issued by such corporation, or

    • (B) 10 times the aggregate adjusted bases of qualified small business stock issued by such corporation and disposed of by the taxpayer during the taxable year.

    • For purposes of subparagraph (B), the adjusted basis of any stock shall be determined without regard to any addition to basis after the date on which such stock was originally issued.

(2) Eligible gain

• • • For purposes of this subsection, the term “eligible gain” means any gain from the sale or exchange of qualified small business stock held for more than 5 years.

    • Important Facts About Investing in QSBS

    • For some taxpayer investors who invest in qualifying small business stock (QSBS), they may be able to avoid paying tax on all of the game up to 10 times the value or $10,000,000. But, in order to qualify for the exclusion, the tax payer must hold the stock for at least five years. In addition, the $10 million limitation applies to joint returns, and not separate returns in which the $10 million is reduced to $5 million dollars.

QSBS Can Be a Lucrative But Risky Investment

In conclusion, the Qualified Small Business Stock investment tool under Internal Revenue Code section 1202 can be a  great way to invest in small businesses — and possibly avoid tax on certain gains. It is important to keep in mind that not all small businesses qualify as QSBS — and in order to qualify to eliminate tax on the gain, the Taxpayer must hold an investment for a significant amount of time in order to reap the benefits.

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