A famous quote by Barry Goldwater “the income tax created more criminals than any other single act by the government”. This is true in many cases as the IRS estimates that there was a total of $1.8B in tax fraud in 2019. There are certain sections of the tax code that were written to not create opportunities to award taxpayers by supporting economic development. Some people will refer to these as “tax loopholes”, but they are merely incentives to reallocate capital into the economy. In this article, we will give a brief summary of Section 1202 Qualified Small Business Stock (QSBS), which is an incentive that has become popular in recent days but is still looked over by many taxpayers.
The QSBS exemption provides up to 100% in capital gains tax exclusion on a federal and in most cases a state level on the sale of stock. The incentive is geared towards incentivizing investors to invest in small businesses that have less access to capital instead of other investment vehicles (e.g. mutual funds). One of the reasons the QSBS election has grown in popularity is because the exclusion was increased from 75% to 100% on September 27, 2010, as well as being excluded from AMT and NIIT. There is a list of guidelines that a taxpayer has to abide by to qualify for the exclusion. Below are the topics for each guideline as well as a link that will walk you through each topic:
- Qualified entity structure
- Qualified industry
- Qualified size
- Active trade or business
- QSBS acquisition criteria
- QSBS timeline
- QSBS gain exclusion cap
- Percent of gain excludable
If you have QSBS or you have an opportunity to receive QSBS, make sure to carefully document that you have met all of the guidelines. If you have successfully documented and followed the guidelines you will be able to exclude $10M or 10x your investment on capital gains received from the sale of your stock. To put this in perspective, assume you have invested $100k in ABC, Inc. and five years later sold the stock for $1.1M. You will be able to exclude $238k* + state taxes + AMT on your gains.
*($1M x 20% capital gains tax rate x 3.8% NIIT rate)
This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.