For any security to qualify under Section 1202 as Qualified Small Business Stock, the company must first be considered an eligible Qualified Small Business (QSB) meaning:
- It is a domestic C-Corp
- It has less than $50 million in gross assets (when the stock is issued)
- It is an active business in a qualified trade
- Learn more about about the additional requirements to be a Qualified Small Business
The securities themselves must also satisfy certain criteria including:
- They were acquired at original issuance
- They were acquired in exchange for money, or other property (not including stock), or as compensation for services provided to such corporation
- They were held for a minimum of five years
For each security type however, when the 5-year holding period begins is determined based on nuances particular to each security type. Depending on the security type, the holding period might begin on the purchase date, the exercised date, vesting date, etc.
What are “Stock Options”?
Stock options are a common incentive given by an employer that give an investor the right to buy or sell a stock at a date and price that is agreed upon between the employer and investor. Usually, options vest (i.e. become available for the holder to exercise/buy) gradually over the employee’s time with the company, helping to ensure employee retention. Stock Options are derived from the underlying value of a security or asset. Majority of the time, the assets are the shares of the company’s stock from which the employer gave to the investor.
These options are purchased as contracts which are equal to 100 shares of the underlying stock. When the contract is written, the strike price, also known as the exercise price, is determined. This defines the price at which an underlying security can be purchased or sold.
An option’s value is based on the difference between the underlying stock price and the strike price.
What are the two types of “Stock Options”?
There are two types of Stock Options. With Non-Qualified Stock Options (NSOs), the holder will pay ordinary income tax from the difference between the granted price of the stock option by the price when the holder exercises the option. In contrast, with an Incentive Stock Options (ISO), the profit upon the ultimate sale of the stock is usually taxed at the capital gains rate rather than being taxed at the higher ordinary income. ISO’s are options that are bought at a discount because of a corporate benefit (i.e. tax breaks) that was given by the company compensating the holder. Furthermore, ISO’s not only are bought at a discount but they have added tax benefits. The Incentive Stock Option may only be subject to the Alternative Minimum Tax (AMT) at the time of exercise.
What are the two types of betting on “Stock Options”?
A “Put Option”: is a bet that the stock will fall. This allows the holder to sell the underlying stock at a predetermined price within a specific time frame. Hence, the predicted drop of value incentivizes the investor to sell the stock at a higher price.
A “Call Option”: is a bet that the stock will rise. This allows the holder to buy the underlying stock at a predetermined price within a specific time frame. Hence, the predicted rise of value incentivizes the investor to buy the stock at a lower price.
QSBS Relation to Stock Options
Pursuant to IRC Section 1202, if certain conditions are met, included but not limited to ensuring that the underlying company meets the QSBS criteria at the time the options are exercised. If the securities are held 5-years after exercise, then the options will also fall under Section 1202 tax exemption and can be exempt from 100% of capital gains tax.
Most simply, an unexercised stock option will never be considered to be QSBS, as QSBS needs to be actual securities as opposed to the right to acquire securities.
When a taxpayer finds themselves in the possession of an ISO of a qualified small business, they have some quick and measured decisions to make. If the options are not exercised before the corporation exceeds the $50mm gross-asset test, the benefit of ever claiming tax exemptions of the long-term capital gains of those shares will be forfeited. However, at the same time, exercising the options may expose the option holder to AMT tax which they would not recoup if they are ultimately unable to ever sell the stock. By exercising your options in QSBS, you’ve now lengthened the holding period for long-term tax exemptions from 1 year to 5 years. Some may agree that the extended holding period in order to qualify under Section 1202 tax exemption is well worth it.
Learn more about Stock Options and QSBS here.
This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.