Taxpayers may be surprised to learn that the appreciated stock they hold could, upon sale, be eligible for a full gain exclusion. This means that no federal income tax is owed after the stock is sold.
Generally, this qualified full small business stock gain exclusion occurs when a taxpayer other than a corporation holds what is called “qualified small business stock” (QSBS) as defined under section 1202 of the Internal Revenue Code. Although the basic rules and requirements for holding QSBS are relatively straightforward, the application of these requirements can sometimes create uncertainties and potential pitfalls for the unwary.
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Here are some of the QSBS exemption requirements when it comes to full gain exclusion:
One frequent issue concerns whether the corporation meets the qualified definition for the small business stock exclusion. A qualified small business must satisfy multiple statutory tests, including:
A qualified trade or business is defined by exclusion, meaning the statute only tells taxpayers what types of businesses are not qualified. Generally, the following service-based businesses are not qualified (note there are also other nonqualified businesses listed in the statute not discussed in this insight):
“...any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees.”
To date, no regulations have been promulgated under section 1202 concerning the definition of a qualified business, leaving some taxpayers with significant uncertainty as to whether their business qualifies. For example, it appears a business is nonqualified if consulting services represent more than 20 percent of its value. With no precise definition of what it means to perform consulting services, a taxpayer and advisers would have to look to case law and other analogous authorities for support to firmly establish whether a company can qualify for the small business stock gain exclusion.
Unfortunately, the government states a taxpayer cannot rely upon another code section (for example, section 199A) and its accompanying regulations for support. Section 199A refers to section 1202 when defining a qualified business for purposes of the 20% deduction for qualified business income. The government has issued extensive regulations under section 199A but specifically stated those regulations do not apply to areas outside of section 199A, including section 1202.
One possible prudent approach individuals can take is to file a private letter ruling request (a PLR) asking the IRS to rule upon whether a business is qualified for section 1202 purposes. We have experience with this process and are happy to discuss the specifics to provide further help and information on the qualified small business stock gain exclusion.
As with many tax benefits, there are significant “traps for the unwary” that can jeopardize the qualified small business stock gain exclusion. Here are a few traps to watch for:
QSBS is a powerful planning tool that can produce significant tax savings when investing. For instance, a single investor forming a qualified business with $49.9 million of capital could exclude up to $499 million of gain (assuming all other requirements are met) upon sale.
Yet holding and maintaining QSBS requires foresight and diligence, and taxpayers should consider consulting with their tax adviser before forming a qualified business and before selling QSBS. This knowledge is critical as you prepare for the future of your business.
Learn more about what types of tax savings can benefit your organization.
This article is provided for general informational purposes only. It is not legal, accounting or other professional advice, as it does not address any individual facts, circumstances or concerns. Before making personal or business related decisions, please consult with appropriate legal, accounting or other qualified professionals.
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