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Traps and trends of the Qualified Small Business Stock
This article was first published by Forbes.
As a tax advisor in the technology space, informing people of the benefits of Qualified Small Business Stock (QSBS) under Internal Revenue Code (IRC) Section 1202 is one of the best parts of my job. It’s a powerful benefit, particularly for founders and investors in the technology industry, that has grown over the last five to 10 years as a planning tool with all of my clients. There have been several great articles written focusing on the benefits and qualifications, including this one by Peyton Carr for Forbes and an extensive article by Tony Nitti for the Tax Advisor. So, if you need to get up-to-speed on how to qualify, I suggest taking the extra time to read through them as my article assumes you have some working knowledge on the subject.
Instead of walking through the basics, I’d like to focus on how my conversations with clients and prospective clients about QSBS have changed recently. The pitfalls around chasing this benefit are increasing each time the Internal Revenue Service or Congress has it in its sights, and it’s important to understand what may be on the horizon. It’s great to inform people they could be sitting on an exclusion of no less than $10 million, but it’s equally as important to make sure they understand the pitfalls and trends, and can make a future-focused decision.
Here are some of the details of the QSBS to pay attention to:
Reading the IRC can often lead to pouring over pages and pages of treasury regulations which help define and refine the more general language of a code section. QSBS and IRC Section 1202 is not one of those instances. IRC Section 1202(e)(3) lists the various businesses that are excluded from the term “Qualified Trade or Business”, but these terms are not defined in any regulations for the purpose of this code section. On the contrary, IRC Section 199A , which was introduced in 2017 to provide a Qualified Business Income (QBI) deduction, has twelve separate sections of regulations to ensure uniformity of treatment and prevent misinterpretation of the rules. Ironically, IRC 199A defines the businesses which do not qualify for a QBI benefit, and it directly reference businesses listed by IRC Section 1202(e)(3).
IRC Section 1202(e)(3) states that a qualified trade or business is any trade or business except for a list of specifically excluded businesses. While there is no specific guidance on how excluded businesses in 1202(e)(3) are defined, the IRS issued a recent Chief Counsel Memo (CCM) which needs to be carefully considered. This CCM addresses brokerage services, a trade or business that is specifically excluded by IRC 1202(e)(3). A company spending significant resources to build out an online marketplace or website might very quickly assume they are a technology company that can qualify for QSBS treatment, but this CCM brings that into question, as it concluded that the activity was actually leasing activity. This conclusion is similar to a prior Private Letter Ruling issued in 2014, in that the IRS came to a conclusion that was likely unexpected and further highlights the fact that, without proper regulations, it is easy to make an incorrect assumption about qualifying for the benefit.
Usually, when a client wants to take a $10 million deduction on a tax return, we’ll do significant work to help ensure the exclusion is valid and, more likely than not, sustainable. However, I frequently speak to individuals that are ready to take a position on QSBS after receiving a simple email acknowledgement from either legal counsel or a CFO. While companies are required under 1202(d)(1)(C) to keep the proper records for both the IRS and its shareholders to meet the requirements of the code section, a shareholder and its advisors should also affirm those conclusions before filing a return. If a corporation is engaged in multiple lines of business, secondary transactions for the founders, or holds significant working capital, a shareholder should make sure that diligence was performed by the company to determine their shares qualify for the exclusion.
Finally, there was no bigger indication that these transactions were on the radar of Congress than the Build Back Better (BBB) tax plan. Although the legislation ultimately failed to pass, the framework included a reversion of the exclusion from 100% of the gain to 50% of the gain. Considering there is also an Alternative Minimum Tax impact of the 50% of the gain that would be taxable, this change would come close to eliminating the benefits of the exclusion for most shareholders. That change was set to be effective for all sales occurring after the date of the legislation’s announcement in September 2021. This means that the best planning could be undone very quickly if these changes were to be revisited.
While there is still a lot to celebrate about QSBS and the potential impact to founders and investors, careful consideration and planning is required to help ensure everything is structured properly.
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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. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, 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.