Article

Qualified Small Business Stock for emerging start-up companies

Oct. 11, 2024 · Authored by Chase Murphy

One of the top tax planning opportunities for start-ups, their founders and investors lies in IRC Section 1202, commonly referred to as Qualified Small Business Stock (QSBS). QSBS provides an opportunity to exclude up to 100% of the gain on a sale of said stock (up to $10 million or 10x basis in the stock, whichever is greater), so long as certain criteria are met. The application of Section 1202 can be complex and unique to each specific situation. Here are some of the top criteria to keep in mind as you determine whether your company qualifies for QSBS:

1. Domestic C-corporation - Stock must be issued from a U.S.-based domestic C corporation. Stock issued by an S corporation or units in a Partnership are not eligible.
2. Original issuance - Stock must be received in an original issuance from the corporation. Acquiring stock in a secondary sale is generally disqualifying.
3. < $50 million asset value at date of issuance - The aggregate gross assets of the company (not its market valuation) must always remain below $50 million, before and immediately after the issuance of stock. Aggregate gross assets are defined as “the amount of cash and aggregate adjusted basis of other property held by the corporation.” The aggregate gross assets of the company could still meet the eligibility criteria even if the fair market value (FMV) of the stock exceeds $50 million.
4. 5-year hold - To qualify for gain exclusion, you must have held the stock for five years. The holding period begins the date the shares are issued, so be mindful of options, convertible notes, SAFE agreements, etc. These mechanisms typically do not start the clock for purposes of QSBS. If you’ve held stock for less than five years, there could be an opportunity to defer gain recognition on a sale via IRC Section 1045 exchange where you roll the gain into another qualified small business activity within 60 days.
5. Qualified trade or business - Certain types of companies are excluded from Section 1202 eligibility; mainly professional service businesses or those where the primary asset of the company is the skill or reputation of the owner(s). Examples of this include banking, finance, insurance, farming, hospitality, healthcare and legal.
6. Estate planning - The maximum gain exclusion per taxpayer is $10 million or 10x basis in the shares, whichever is greater. There is also an opportunity to consider multiplying the exclusion through estate planning mechanisms, such as stacking gifts to certain types of trusts.

There are many factors that should be considered based on the facts and circumstances of the individual business, including: material redemptions, exercising of options, sale structure, etc. Consult with Baker Tilly’s tax advisors familiar with the nuances of the rules to understand how they might apply to your company.