Issuing qualified small business stock (“QSBS”) is a valuable tool that can provide significant tax savings to searchers and independent sponsors alike upon the eventual sale of one or more of their portfolio companies. Taxpayers who hold QSBS for more than five (5) years can, upon selling the QSBS, exclude from taxable gain for federal income tax purposes the greater of $10,000,000 or ten times (10x) the tax basis in the stock. With proper pre-transaction planning between legal counsel and tax advisors, searchers and independent sponsors can not only take advantage of QSBS taxable gain exclusions themselves, but pass these tax benefits onto their investors as well. If properly handled, QSBS can therefore make an investment opportunity more attractive to prospective investors.
While QSBS can limit or eliminate entirely the taxes otherwise payable by searchers, independent sponsors, or their investors upon the eventual sale of a company, stockholders (both direct and indirect) and the QSBS-issuing corporation must satisfy many specific rules set forth in the tax law[1] in order for stock to qualify for QSBS treatment.
Some of these rules are:
- C Corporation Stock: QSBS treatment is available only to stock of a domestic C corporation.
- Original Issuance: The C corporation stock must be acquired by “original issuance” in exchange for property (which cannot be corporate stock), cash, or services, and not otherwise acquired from a third party.
- Gross Asset Limit: The aggregate gross assets of the C corporation at all times until immediately after the stock issuance cannot exceed $50,000,000.
- Required Holding Period: For a taxpayer to take advantage of the QSBS gain exclusion, they must hold the stock for a minimum of five (5) years.
- Qualified Trade or Business: The C corporation must be engaged in a “qualified trade or business.” For QSBS purposes, a “qualified trade or business” cannot include specific kinds of businesses, including (but not limited to): (A) a business providing professional services (e.g., consulting, health, law, architecture, accounting, or engineering), or a business where the principal “asset” of the trade or business is the reputation or skill of one or more of its employees; (B) banking, insurance, financing, investing, or similar businesses; and (C) the operation of a hotel, motel, restaurant, or similar business.
- Active Trade or Business: At least eighty percent (80%) of the assets of the C corporation must be used in the active conduct of the qualified trade or business.
- Redemptions: Certain stock redemptions by the C corporation (including redemptions before and after the issuance) may disqualify all or part of the issued stock from QSBS treatment. This is a trap that must be closely monitored.
While on the surface it may appear that, due to the original issuance rule, the acquisition of an existing business might prohibit searchers, independent sponsors, and their investors from taking advantage of QSBS treatment, careful pre-acquisition planning by legal counsel and tax advisors can unlock these tax benefits.
The above summarizes some of the QSBS requirements, but it is by no means exhaustive, and is not intended to address state income tax. Hinckley Allen’s Entrepreneurship Through Acquisition (ETA) team has extensive experience counseling searchers and independent sponsors on the requirements of the QSBS rules and working hand-in-hand with outside accountants to structure acquisitions in a way that can unlock the potential value of QSBS treatment.
[1] See Section 1202 of the Internal Revenue Code of 1986, as amended, and the Treasury Regulations promulgated thereunder.
