The Hottest Deal in the Tax Code – Qualified Small Business Stock


For start-ups, emerging companies and their investors, the hottest deal in the U.S. Internal Revenue Code is now found in Section 1202, which governs Qualified Small Business Stock.  QSB Stock, as it is known, is stock of a C-Corporation that is taxed at a very low rate if it is sold after a 5-year holding period and certain other tests are met. At present, this rate is about 15% (compared to roughly 23.8% for non-QSB stock).  In 2014 this rate will go to about 8-9% for some taxpayers, and in 2015 will reach 0% (!).

QSB Stock provides a fascinating tax incentive for early-stage companies and their investors. However, it remains to be seen whether an extremely low tax cost will drive entrepreneurs to create more companies and spur investment in these companies. Most likely, in the small and mid-market M&A world, the emergence of QSB Stock will fuel increased deal activity over the next few years.

If you are an investor, entrepreneur or would-be acquirer, here are a handful of things to keep in mind.

What exactly is QSB Stock?  QSB Stock is common or preferred stock issued by a U.S. C-Corporation to a non-corporate shareholder in exchange for cash, property or as compensation for services. As a general rule, the original owner of the stock must acquire it from the issuing C-Corporation and hold it for five years. (S-Corporation stock does not qualify.) At the time of issuance (and in all prior periods, going back to August 10, 1993), the fair market value of the issuing corporation must be no more than $50 million, including any proceeds from the issuance itself. The stock of many service-oriented businesses does not qualify as QSB Stock – including companies in the health care, law, engineering, performing arts, consulting and financial services industries. Among other rules, for each taxpayer, the special tax savings only applies to $10 million of gain per company.  For example, a fortunate angel investor could harvest a QSB Stock benefit on multiple sales of stock in different companies in one tax year. The gain eligible for the lower rates would be limited to $10 million per company.

Why haven’t we heard much about QSB Stock in recent years? Blame Congress. QSB Stock was first put in place in August of 1993, but the tax benefit has always been subject to a five-year holding period. So this particular tax break never offered an immediate pay off. Also, Congress set 28% as the statutory tax rate for QSB Stock and then excluded a portion of gain (i.e., 50%, 75% or 100%, depending on the acquisition date) from this tax rate. To meet revenue goals, Congress then clawed back most (or even all) of the tax savings by treating the excluded portion of the gain as an add-back item for the Alternative Minimum Tax. Thus, what Congress gave with one hand it effectively took away with the AMT. Finally, long-term capital gain rates have recently been very low (15% for most individuals) from 2003 to 2012, which meant that the QSB Stock benefit at the 50% exclusion level was never going to be much better than the standard 15% tax rate for long-term capital gains.

But all of this changed suddenly in 2013.  As of January 1st of this year, Congress increased the long-term capital gain rate to 20% and extended the 100% exclusion (i.e., a 0% rate) for QSB Stock acquired in 2012 and 2013. Also, Congress eliminated the AMT add-back for QSB Stock eligible for the 100% exclusion, and greatly reduced the add-back for QSB Stock eligible for the 50% and 75% exclusion ratios. On top of these changes, the Affordable Care Act ushered in a special 3.8% Medicare tax in 2013 that will hit most large capital gains, but at present does not appear to apply to QSB Stock gains. When you take all of these changes into account, you get a number of happy results for taxpayers who own QSB Stock, as illustrated in the table below:

Date that you originally acquired QSB Stock . . . assuming you meet all QSB Stock requirements, including 5-year holding period . . . Portion of gain excluded from tax Effective federal tax rate on QSB Stock gain ($10 million max gain per company)*
Aug. 11, 1993 to Feb. 17, 2009


14.98% to 16.88%

Feb. 18, 2009 to Sept. 27, 2010


8.47% to 9.42%

Sept. 28, 2010 to Dec. 31, 2013



 *The rates for the 50% and 75% categories assume that 50% and 75% of the gain is taxed at the statutory QSB Stock rate of 28%, and a portion of the excluded gain (7%) is subject to AMT at 28%. The higher end rates in these two categories assume that 50% and 75% of the gain respectively is excluded from the new 3.8% Medicare add-on tax imposed under the Affordable Care Act. See Internal Revenue Code Sections 1(h)(7); 57(a)(7); 1202(a); and 1411(c)(1).

Next Steps for Investors and Entrepreneurs.  Anyone starting a business or investing in one should take special care to understand the tax rules involving QSB Stock. In particular, this issue has new importance to start-ups – e.g., on matters such as entity choice, stock option versus restricted stock grants, and investment security offerings (e.g., stock versus convertible debt).

For established companies and acquirers considering an exit or an acquisition, the key issue is to determine whether any existing shareholders hold QSB Stock and how that will affect a future transaction. In certain cases, it may be prudent to delay an exit in order to permit some or all shareholders to enjoy the lower tax rates. In other cases, it may be possible to carry out a tax-free merger or reorganization and “roll over” the QSB Stock benefit into new stock issued by the acquiring company, or engage in a taxable deal and permit sellers of QSB Stock to invest their gains into QSB Stock of a different company.

Finally, even if no sale is on the horizon, there are tricky redemption and other qualification rules that companies should be careful to follow. In particular, note that certain major stock redemptions (which are common in the context of a departing founder) can disqualify the QSB Stock benefit for all stock issued within a 2-year span of the redemption (or a 4-year span if the QSB Stock owner is the one who is redeemed). There are also hard-luck cases. For example, S-Corp stock does not qualify, and neither does stock purchased from another shareholder.

All of these issues merit a careful review and certain aspects of Section 1202 are not entirely clear. As such, you should consult with your tax advisor and counsel with regards to updates to the tax code regarding QSB Stock, and, as always, when entering into any transaction involving the purchase or sale of equity of any kind.

In many cases, it is clear that the benefit of this particular tax break is considerable . . . and is finally taking hold in the marketplace.

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