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07/22/2024
The Qualified ‘Small Business’ Stock exclusion: A rare gift for taxpayers
The QSBS capital gains exclusion is unique because if you qualify, there is no catch – potentially resulting in huge tax savings for tech startup investors.
What makes the Qualified Small Business Stock (QSBS) capital gains exclusion so unique among tax provisions is that if you qualify, there is no catch. This can result in a huge tax savings for investors in technology startups.
IRC Section 1202 allows a capital gains exclusion for individuals, as well as other entity types, on the sale of C Corporation stock. While the rule itself uses the term “small business” – for example, one requirement is that the aggregate gross assets of the business must be $50 million or less at all times during the company’s existence – with the amount of the exclusion from capital gains being (up to) the greater of $10 million or 10 times the taxpayer’s basis in the stock, the tax savings can become substantial, quickly.
To understand the QSBS exclusion, let’s review an example:
Assume that Alex, an individual, started a technology company on Jan. 1, 2015, and purchased the stock of his qualifying C Corporation at that time. Alex’s basis in the stock was $3.5 million.
On Jan. 1, 2024, Alex sold his stock for $30 million, resulting in a gain of $26.5 million.
Using the QSBS exclusion, Alex can exclude 10 times his basis, up to $35 million. As a result, he saves $6.3 million in federal capital gains ($26.5 million gain x effective capital gains rate of 23.8%).
Alex’s capital gains savings is not limited to $6.3 million, either – most states will allow a QSBS exclusion as well.
There are a number of qualification requirements in order to obtain the QSBS exclusion. We have found that the most common disqualifying requirement for technology companies is generally the “qualified trade or business requirement;” specifically, Section 1202 excludes a number of specified trades or businesses, including a business that is in the field of consulting, among others.
The one small catch (and how CohnReznick can help)
With these significant exclusions of capital gains comes the risk of being audited by the IRS. CohnReznick’s Technology Tax Consulting practice can provide you with a QSBS Documentation Memo to help defend yourself in the event of an audit. We will review your financials, line of business, historical basis, and other key qualifying details, and arm you with a substantial memorandum that provides you with a detailed and extensive defense to support that you qualify for the QSBS exclusion.
Reach out to see if you qualify for these significant tax savings.
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Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute legal or professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice specific to, among other things, your individual facts, circumstances and jurisdiction. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick, its partners, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.