Tax, as we once knew it, is undergoing another overhaul. Some taxpayers may be up against a near 40% federal capital gains rate in 2021; Qualified Small Business Stock (“QSBS”), also referred to as §1202 stock, is ever so crucial to start-up companies and early investors as a viable tax planning strategy for capital gains.
Under Internal Revenue Code §1202, individuals which fit the criteria may be eligible to exclude up to $10 million of capital gains from federal tax (or 10 times the adjusted basis of the stock) on the sale of QSBS. These rules were first introduced in the Revenue Reconciliation Act of 1993, later amended by the Creating Small Business Jobs Act in 2010, which generally allows a 100% exclusion up to the $10 million threshold acquired after 2010.
QSBS is any C Corporation stock issued after 1993, which is also a qualified small business, whose stock is acquired in exchange for money, property, or compensation for services, and is held for at least five years. In addition, a qualified small business is generally a domestic C Corporation, which aggregate gross assets do not exceed $50 million, and is an active business. Furthermore, an active business generally meets its requirement under §1202(e) if 80% of its assets are used to conduct its trade or business. The Code also includes a list of ‘except for’ businesses that are specifically excluded; typically, a trade or business in which its principal asset is the reputation or skill of one or more of its employees (i.e. health, law, arts, etc.).
The opportunities for QSBS tax savings continues in the realm of fiduciary taxation for estates and gifts. In the event capital gains on the sale of QSBS exceed an individual’s $10 million threshold, gifting QSBS may be a consideration as §1202(h) allows the recipient of the gift similar tax benefits of the $10 million exclusion.
The list of requirements and intricacies of the §1202 rules goes on. The takeaway is to plan on the exit from the very beginning to mitigate the tax impact on capital gains.
Lou Sierra, MST, is a Senior Tax Accountant at Katz, Nannis + Solomon, P.C. If you have any questions or would like to speak with one of our tax professionals, please contact our office at 781-453-8700.