UNDERSTANDING QUALIFIED SMALL BUSINESS STOCK & THE CAPITAL GAINS EXEMPTION
by Anne Lucchesi, Head of Founder Advisory Services published on March 20, 2017
This article originally posted on the Silicon Valley Bank Blog. Reposted here with SVB's permission.
Benjamin Franklin suggested that death and taxes were life’s only certainties. But perhaps his advisors didn’t know enough about the Qualified Small Business Stock (QSBS) exemption. So if you are facing a potential taxable event from shares you acquired in a private company, 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, you need to be aware of certain qualifications that could help you protect up to $10 million (or 10 times your cost basis, whichever is greater) from federal taxes.
The Basic Requirements
You must meet several key requirements to benefit from the QSBS exemption. 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.
The other key requirement is to understand when and how you acquired the stock. This requirement has been in place since 1993, but it has since undergone a few improvements. The table below lays out the actual savings based on the date you acquired shares:
|Date Acquired||Exclusion %||Effective Regular Tax & Net Investment Income Tax Rate||Effective AMT & Net Investment Income Tax Rate|
|On or before Feb. 17, 2009||50%||15.90%||16.88%||Feb. 18, 2009 to Sept. 27, 2010||75%||7.9%||19.42%|
|Sept. 28, 2010 or later.||100%||0%||0%|