Qualifying For The Qualified Small Business Stock

Posted on September 13, 2012

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As we covered last week, the appeal of C-Corporations lies largely in their greater flexibility to find investors. Many VC firms will only work with C-Corporations, C-Corporations have unlimited domestic and foreign shareholders and C-Corporations can offer different levels/types of stock. The Qualified Small Business Stock (QSBS), the 50% tax break on gains that goes to non-corporate shareholders who keep their stock for at least five years, is another factor when it comes to evaluating C-Corporations.

In order to qualify for QSBS status, the company (also known in the statute as the issuer) must meet the following criteria:

• Have incorporated as a C-Corp in the United States; and according to the IRS section 1202,

  • • Aggregate gross assets of such corporation (or any predecessor thereof) at all times on or after the date of the enactment of the Revenue Reconciliation Act of 1993 and before the issuance did not exceed $50 million.
  • • Aggregate gross assets of such corporation immediately after the issuance (determined by taking into account amounts received in the issuance) do not exceed $50 million.
  • • Such corporation agrees to submit such reports to the Secretary and to shareholders as the Secretary may require to carry out the purposes of this section.

The stock must meet these criteria:

  • • Have been “originally issued” by a qualified small business.
  • • Have been issued by a qualified trade or business during at least 80% of the holding period. Qualified trades or businesses do not include “any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services” or “any business of operating a hotel, motel, restaurant, or similar business.”
  • • There can be no redemptions from the taxpayer or related person, meaning “stock acquired by the taxpayer shall not be treated as qualified small business stock if, at any time during the 4-year period beginning on the date 2 years before the issuance of such stock, the corporation issuing such stock purchased (directly or indirectly) any of its stock from the taxpayer or from a person related to the taxpayer.
  • • There can be no “significant redemptions,” meaning “stock issued by a corporation shall not be treated as qualified business stock if, during the 2-year period beginning on the date 1 year before the issuance of such stock, such corporation made 1 or more purchases of its stock with an aggregate value (as of the time of the respective purchases) exceeding 5 percent of the aggregate value of all of its stock as of the beginning of such 2-year period.”

In addition, according to the IRS:

  • • “Gross income shall not include 50 percent of any gain from the sale or exchange of qualified small business stock held for more than 5 years.
  • • The aggregate amount of such gain from dispositions of stock issued by such corporation which may be taken into account under subsection (a) for the taxable year shall not exceed the greater of —
  • (A)$10,000,000 reduced by the aggregate amount of eligible gain taken into account by the taxpayer under subsection (a) for prior taxable years and attributable to dispositions of stock issued by such corporation, or
  • (B)10 times the aggregate adjusted bases of qualified small business stock issued by such corporation and disposed of by the taxpayer during the taxable year.”

The problem with the tax credit is that it takes five years to reap any benefit, so you are setting something up for a future benefit, and that benefit may not come to pass. For example, you may want to sell in year three. You do not want the tax benefit to let you lose sight of a potential good business benefit. However, if you do qualify then the capital gain benefit could be huge. If you invest in a C-Corporation and the C-Corp reinvests in growth, then they may not have any net income until they are ready to sell. If they complete a stock sale and your stock qualifies as a QBSB, then you may have more tax savings than you did as a flow through LLC or S-Corporation.

While the credit may not be as good as it was in the past (in previous years it has been as much as 75% or 100%), the size of the benefit may increase substantially if capital gains rates increase.  If you are thinking about forming a C-Corporation, this tax benefit is a potential positive.1

Mike Goodrich
Goodrich Law Firm, LLC

1 For the record, while I still recommend S-Corps or LLC for clients (see last week’s footnote), when faced with the choice for a personal investment, I went the C-corporation route and structured in hopes of taking advantage of this tax credit.

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