Qualified small business stock (QSBS) is a type of investment that gained special tax treatment in 1993 as part of the Revenue Reconciliation Act. The move was intended to incentivize investment in small businesses. Since its introduction, however, Section 1202 of the Internal Revenue Code, which governs qualified small business stock, has been amended to provide much more robust incentives. As a result, employees who receive QSBS from their employers can now enjoy far greater tax savings.
Do I own QSBS?
If you’ve been awarded stock options or shares in your company, it’s important to understand whether these shares meet the definition of qualified small business stock. First, your company must meet certain criteria:
- Domestic C corporation
- Less than $50 million in assets at the time stock is issued
- Uses at least 80% of assets for business operations
- Does business in a qualified industry
- Service industries (e.g., hospitality, farming, mining, finance) are generally excluded from QSBS. Technology, retail, wholesale, and manufacturing businesses typically qualify.
As the shareholder, you also must meet specified criteria for your stock to be considered QSBS:
- You must have acquired the stock directly from the issuer (e.g., your employer) rather than from another person or on the secondary market.
- You must have obtained the stock in exchange for cash or property or as compensation.
- You must hold the stock for at least five years before selling it.
How can I get the most benefit from my QSBS?
If your company shares meet the definition of qualified small business stock, you have the potential for tremendous tax savings. If you and the issuing company meet all the necessary criteria, the proceeds from your sale of your shares could be exempt from federal taxes.
When IRC §1202 was enacted in 1993, it allowed covered shareholders to exclude 50% of the gain from QSBS from federal taxes and 7% of the gain from the alternative minimum tax (AMT), an alternate calculation that requires high-income taxpayers to add back in tax preference items to ensure they pay at least a minimum amount of tax. Since that time, amendments have greatly enhanced this benefit.
- Gains from the sale of QSBS acquired between February 18, 2009–September 27, 2010 are 75% exempt from federal tax (with 7% still reportable for the AMT)
- Gains from the sale of QSBS obtained after September 27, 2010 are 100% exempt from federal tax and are not reportable for AMT calculation.
Keep in mind, however, that there is a cap on this exemption. A shareholder may exempt no more than $10 million or 10 times their basis in QSBS sold in a given year.
As you can see, the tax savings potential of QSBS is exceptional. To maximize your possible tax benefits, make sure to address the following:
Consider filing an 83(b) election.
If your company gave you stock options or restricted stock, you may be able to file an 83(b) election within 30 days of the exercise or grant date. IRC §83(b) is a provision that allows employees and other early investors in a company to be taxed on the bargain element of their shares before they vest. This can be beneficial because the share price at the time of granting is often at or near the strike price, making the bargain element zero or nearly zero.
To make an 83(b) election on a stock option, you must first exercise the option; as a result, this choice is available to option holders only in companies that allow early exercise. If you file 83(b) within 30 days of early exercising ISO shares, then the bargain element will be included in your AMT calculation for that year. For nonqualified (NSO) shares, the bargain element is reportable as ordinary income.
Restricted Stock Awards
Because a restricted stock award (RSA) is a grant of company stock, there is no option to exercise. If you hold an RSA, then you can file an 83(b) election within 30 days of the grant date. The bargain element will be taxed as ordinary income.
While 83(b) elections can often save taxpayers money, this is not always the case. If you end up selling shares for less than their fair market value at the time of the exercise, for example, you will not be entitled to a refund of the taxes you paid as a result of the 83(b) filing. It’s also important to plan for the tax consequence of your 83(b), since taxes will be due long before you will see any income from your shares. To determine whether an 83(b) election is likely to benefit you, consult with a trusted investment advisor who has experience assisting IPO employees.
Hold QSBS shares for at least five years.
It’s important to remember that to get federal tax exemption for the proceeds of a QSBS sale, you must hold shares for a minimum of five years. If you file an 83(b) election, the filing starts the clock on this five-year holding period. Otherwise, the clock starts when your shares vest. The IRC does create one exception to the five-year rule, however. An investor who holds QSBS for at least six months but sells it within the five-year holding period can defer their gains on the sale by reinvesting them in other QSBS within 60 days.
Consult with an experienced IPO advisor.
When your company begins the process of entering the public markets, whether through IPO, SPAC merger, or direct listing, your financial picture can change rapidly. You’ll have a host of new decisions to make that can profoundly impact your future. A fiduciary financial advisor who is well versed in the IPO process is a valuable ally who can guide you every step of the way and help you create the future you envision.
The experts at WRP have extensive experience guiding clients through the IPO process. For more information and insights on how to get the most out of your company’s IPO, check out our free resource library or browse our blog.