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K. A. Lindow, CPA, P.C. CPA Firm, Phoenix, AZ.

Qualified Small Business Stock

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Qualified Small Business Stock (QSBS) for a Tax-Free Gain

Structure a business to be eligible for tax-free profits.

QSBS

A Qualified Small Business Stock (QSBS) allows anyone to start or buy a business using either a personal cash investment or by rolling over other types of assets (not retirement funds) as initial investment to purchase stock. A QSBS is classified as original issue stock within a domestic C Corporation, where the company is typically involved in retail, wholesale, or a technology business. Under section 1202 of the Internal Revenue Code (IRC), a QSBS excludes any business, where the principal asset is the reputation or skill of any one or more of its employees, such as any financial services, farming, healthcare, hospitality industries, law, engineering, architecture, etc.

The benefit of operating under a QSBS is the ability to obtain the buildup of business asset value which can be sold for tax-free profits in the future. Unlike a 401(k)ROBS, there is a maximum amount of assets that can accumulate, which is $50 million. Of those $50 million, 80 percent of those assets must be used in a qualified active business, to conduct the trade of business. Furthermore, there is a maximum amount of  gain that is allowed to become tax-free.

Upon the sale of the business, all sales profits up to the greater $10 million or 10 times the stock basis, will become tax-free and available at any age to the business owner. In order to benefit from the tax- free benefits, the investor has to have a five-year holding period of the stock. Any QSBS is required to be held for six months. If sold after the six months, then you have 60 days to reinvest in another QSBS stock program to avoid any taxation. If you already own a business, it can be converted over to begin the five-year holding period for the QSBS.

General Components in Both Programs Under a C Corporation

  • In the QSBS it is important to note, that any other corporations cannot own the stock in the entity.  The investment is either made through your own personal assets such as a other personal assets rolled over to a QSBS.
  • As an investor, you have the ability to become an employee in your own business, taking a salary as compensation with fringe benefits.
  • Programs may acquire and hold property (land), but it is advisable not to hold property within a C Corporation due to double taxation and with the QSBS corporation there are limitations on the amount of assets that are not devoted to business operations.
  • All annual business profits will be required to be taxed as a C Corporation in both types of entities.
  • Under a C Corporation, if stock is inherited or acquired through a gift, the new owner will step in and continue the five-year holding period requirement from the new original owner in a QSBS.  

Financial Records Needed

  • Under a QSBS, individuals and corporations need to be able to document the date of acquisition, amount, and stock basis, for all originally issued stock.

It is important that the company also certify the following:

  • Verify that it is a domestic C Corporation
  • Has $50 million or less in aggregate gross assets, if property/assets are transferred to the corporation, it must be valued at its Fair Market Value (FMV) at the time of contribution.
  • At least 80 percent of the company assets must be used in the active conduct of qualified QSBS business (such as operations research and experimentation or investments for future working capital and startup activities).

Summary

If all rules and regulations are adhered to a great deal of taxes can be avoided upon the sale of either a QSBS Corporation. With a QSBS Corporation the amount of the gain that can be avoided for taxation is set at $10 million or less.

For further information on whether your business qualifies as a QSBS refer to the QSBS Checklist in compliance with Internal Revenue Code Section 1202.


Tax Due Dates