Benjamin Franklin suggested that death and taxes were life’s only certainties. Sadly, his advisors were not aware of the Qualified Small Business Stock (QSBS) exemption. If you are facing a potential taxable event from private company shares you acquired, understanding the ins and outs of Section 1202 of the Internal Revenue Code (IRC) just might ease the pain of one of life’s inevitabilities.
Section 1202 of the IRC is commonly referred to as the QSBS exemption. If you are a founder, angel investor or an employee of a successful early-stage company, certain qualifications can help you protect up to $10 million (or 10 times your cost basis, whichever is greater) from federal taxes.
The Basic Requirements
To benefit from the QSBS exemption, you must meet several key requirements. Particularly, you must have held your stock in a Qualified Small Business for at least five years. For purposes of this part of the tax code, a Qualified Small Business is defined as:
- A domestic C Corporation
- An entity with cash and other assets totaling $50 million or less, on an adjusted basis.
- Any business other than: (a) services firms such as health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial or brokerage services, (b) banking, insurance, financing, and similar businesses, (c) farming, (d) mining and other natural resource businesses (e) operation of hotel, motel, restaurant, or similar business.
- An entity that is actively running a business. In other words, at least 80% of the assets of the firm must be used to actively run the business, not for investment purposes.
It’s critical to ask yourself: How does one qualify for this potentially powerful exemption? The first requirement is that you must have acquired the stock directly from the issuing company for cash, services, or property (including IP). Thus, if shares are acquired through a secondary transaction, they would not qualify. It is also important to note that the shareholder must also be a non-corporate taxpayer; however, flow through entities may pass through eligibility.
Read other key requirements and important subtle issues you should understand here.
By Ann Lucchesi, Managing Director, Enterprise Relationship Management
Published May 2, 2022