10 RULES FOR QUALIFIED SMALL BUSINESS STOCK

Some businesses can issue stock that entitles owners to eventually obtain tax-free income when they sell their stock. Yes, 100% of gain on the sale of qualified small business stock, or QSBS (also called Section 1202 stock after the section in the Tax Code governing it) may be excludable from gross income. But there are many restrictions that limit the utility of this wonderful stock break.

Here are 10 rules to note:

1. The corporation must be a C corporation

An S corporation cannot issue qualified small business stock. The corporation must be a regular corporation, meaning a C corporation.

2. The corporation can’t be involved in certain industries

Basically, the corporation cannot be one involving personal services (e.g., those performed in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services); banking, insurance, financing, leasing, or investing; farming; mining; or operating a hotel, motel, or restaurant.

3. The stock usually must be acquired from the corporation

Shareholders must acquire their stock for cash, property, or as payment for services from the corporation (those acquiring QSBS as a gift or inheritance can still get the tax break). 

4. The corporation must be a domestic corporation

On the date the stock is issued, the corporation must be a domestic corporation. Foreign corporations operating in the U.S. cannot issue qualified small business stock.

5. The corporation must be of a certain size

As of the date the stock was issued, the corporation must have total gross assets of $50 million or less. This asset limit applies prior to issuance and immediately after issuance of the stock. Gross assets include those of any predecessor of the corporation.

6. The corporation must be an operating corporation

The corporation can’t be a mere holding company; it must be engaged in a business within a permissible industry.

7. The amount of the exclusion depends on when the stock was issued

The amount of gain excludable depends on when the stock was acquired:

• A 100% exclusion of gain applies for stock acquired after September 27, 2010.
• A 75% exclusion of gain applies for stock acquired after February 17, 2009, and before September 28, 2010. 50% exclusion of gain applies for stock issued before February 19, 2009.

8. Stock must be held long enough

Regardless of when the stock was issued, it must have held it for more than 5 years to obtain an exclusion.

9. The amount of gain excludable is capped

The exclusion cannot be more than the greater of $10 million ($5 million for married persons filing separately), minus any gains excluded in prior years, or 10 times the shareholder’s basis in QSBS. Lower limits applied to married persons filing separately.

10. The excluded gain impacts other tax rules

The excluded gain has consequences beyond tax-free income.

• The portion of the gain not excluded on stock issued prior to September 28, 2010, is taxed at a capital gain rate of 28% (not the usual 15% or 20% on most other long-term capital gains).
• The excluded gain is not treated as investment income in figuring the limit on the itemized deduction for investment interest.
• The exclusion is not taken into account in figuring a net operating loss deduction.

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