Small business is the core of American business, generating 44% of U.S. economic activity and two-thirds of net new jobs over the past 25 years, according to the U.S. Small Business Administration.
Yet many small business owners are unaware of Qualified Small Business Stock (QSBS) programs as a strategic option to save taxes, and how they and their investors might benefit. This plan’s tax benefit was initially instituted in the early 1990s to encourage investment and growth in small business.
QSBS is stock developed by an active, domestic C corporation whose gross assets—valued at the original cost—do not exceed $50 million on and immediately after its private stock issuance. In a QSBS program, shares of a qualified small business can be set up to share profits with employees and may be used as a form of irrevocable trust to help business owners save money upon sale of the business.
While these plans may not be a fit for some companies in service industries, QSBS strategies can be good for those in manufacturing, technology and other product-centric industries. When used correctly, QSBS can be a powerful strategy for employee stockholders and owners of a company to keep more gains from the stock upon sale of the company and can be used with other financial strategies.
Upon sale of the company, the seller and investors may be able to defer taxes on up to 50% if owned between 1993 and February 18, 2009, 75% if purchased between February 18, 2009 and September 27, 2010, or 100% if purchased after September 27, 2010 of the gains from the sale of qualified small business stock, providing the stock has been held for over five years. Note that there may be a nominal amount of Alternative Minimum Tax due.
Below, we address some of the common questions asked about QSBS usage. All small business owners should discuss it with their own CPA, accountant and/or financial advisor before making any decisions about QSBS applicability to their own business.
For what types or sizes of businesses is a QSBS appropriate?
Only small businesses that meet the Internal Revenue Code Section 1202 – specifically, active domestic C corporations with gross assets that do not exceed $50 million, when valued at original cost on and immediately after its stock issuance – qualify for QSBS. There are other state-level requirements and restrictions to consider as well, which should be discussed with the business’s CPA and/or financial advisor.
How is it developed?
It is used by C corps and their ownership/leadership, which creates shares in the company and then either keeps 100% of the stock or gives an equity stake to key employees or investors. QSBS is only monetized upon sale of the company and the company must be a C-corporation for at least 5 years before anyone can gain from this tax advantage. In some cases, investment groups may pool money and invest in the company, and then they would get an equity slice as a consortium. Individuals could gain a tax benefit in comparable percentage to what they invested.
QSBS stacking – its biggest advantage
Its biggest advantage is as a powerful tax strategy. When the company sells to a strategic buyer, the first $10 MM in gain is tax free. Another $10mm (or less) for each eligible shareholder can be put into irrevocable trusts for their children or spouse, also tax-free. This opportunity makes a lot of sense for companies that may have larger exits. The money also could be given to a charity or other foundation, which then also receives the tax benefit.
Some owners of smaller businesses may not know about the tax advantages or ability to save money by setting up these irrevocable trusts. In an irrevocable trust, the benefactor relinquishes the right to ever touch those funds again, so they should be sure they want to give away this money.
What benefits does it offer to the issuing company?
It can also be used as a recruitment or retention strategy for key employees. The issuing company can put some stock into a profit-sharing program for employees as long as it’s not into a qualified plan (like 401k, which is qualified.)
There is no tax benefit while the company is still operating under initial ownership; it comes just at the point where an exit occurs and stock is sold or acquired by another company. It makes no difference if the company is B2B or B2C.
What benefits does it offer to its investors?
Any stockholders held to the same tax rules gain similar tax benefits. A noncorporate shareholder may be able to exclude 50% to even 100% of the gain from the sale of qualified small business (QSB) stock that has been held for at least five years. It is critical to work with an expert in QSBS programs who adheres to Federal Tax Law 1202.
Are there any additional requirements or restrictions that need to be mentioned?
Each state may handle it differently. California, for example, doesn’t recognize the tax breaks so the business seller still has to pay state tax on the sale. Other, more tax-friendly, states may not handle it like California does, but businesses would probably have to be headquartered in that other state for a set amount of time. State law applies to wherever the business is incorporated, as well as to where the business owner lives. Most likely, each shareholder would have to pay taxes to the state where they live, if that state has state income tax.
How would this best apply to manufacturing or tech companies?
QSBS can work quite well for any companies that start small but anticipate a large-scale exit, perhaps especially for those that might have venture-capital investors. However, even in a smaller-scale exit where the founder owns most of the shares, maybe backed by a few family and friends, the tax benefit works the same way. The first $10 million gain in the sale is federally tax-free.
We recommend that business owners who anticipate considerable growth in their businesses discuss QSBS with their tax accountants and financial advisors.
Luke Ervin is senior vice president, Wealth Management, and a financial advisor, UBS. He oversees financial affairs for a select group of business owners, entrepreneurs, corporate executives, professionals and their families.