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As investors hear more and more about the qualified small business stock tax exemptions, they may be looking at their own portfolio and assets to see where this capital gains exclusion can benefit them.
Stock Options can qualify for the QSBS tax exemption, 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 and if the securities are held 5-years after exercise.
What Are Stock Options – The Basics
Stock options are a common incentive offered to attract new employees or to retain employees. The stock option gives the employee the non-obligatory right to purchase a certain amount of shares in the company at a discounted price. Usually, options vest (i.e. becomes available for the holder to exercise/buy) gradually over the employee’s time with the company, helping to ensure employee retention.
Option holders need to then determine whether or not to exercise their options, and consider the tax implications for doing so. There are two main types of options:
- Non-Qualified Stock Options (“NSOs”) – wherein the holder pays ordinary income tax on the difference between the grant price and the price when they exercise the option.
- Incentive Stock Options (“ISO”) – whereby the profit upon the ultimate sale of the stock is usually taxed at the capital gains rate, and the options may only be subject to the Alternative Minimum Tax (“AMT”) at the time of exercise.
How Does QSBS Affect Stock Options
According to section 1202 of the IRC, many factors are at play when determining the eligibility of qualified small business stock.
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 is surpassed, the benefit of ever claiming tax exemptions of the long-term capital gains of those shares disappears. 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.
In addition, by exercising your options in QSBS, you’ve now lengthened the holding period for long-term tax exemptions from 1 year to 5 years.
Regardless of these complex considerations, if someone has stock options in a growing Qualified Small Business (“QSB”), exercises the options and holds the stock for the necessary 5-year holding period before ultimately selling the stock for a gain, the end-game of excluding 100% of the capital gains from your taxes may prove to be worth it.
- When obtaining stock options in a qualified small business, it is important to act sooner than later in exploring the potential benefit of exercising those options. See: Should I Exercise my Options Now?
- To meet the requirements of a QSB, according to section 1202 of the tax code, a company cannot have more than $50mm in gross-assets at the time of exercise.
- A 5-year holding period may be a turnoff to exercising QSBS options, but when you consider the possibility of a 0% tax on long-term capital gains, exercising the options to later benefit from the QSBS tax exemption may result in an increased overall gain.
This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.