Updated: Jul 25, 2022
Qualified Small Business Stock (QSBS, also referred to as Section 1202 stock (the section in the Tax Code that governs it) can be a valuable part of tax planning and strategy, including for tech startups.
In order to utilize QSBS:
The issuer must be a C corporation in the U.S. (no S corps).
The corporation’s assets must be $50 million or less at all times after August 9, 1993 before and after the issuance of the stock.
The corporation must be an active business (not a holding company) at all times that the stock is held.
The corporation must be in a business other than one: involving personal services; banking, insurance, financing, leasing, investing; farming; mining; or operating a hotel, motel, or restaurant.
Both the corporation and the shareholder must consent to provide certain documentation for the stock.
The stock must be acquired directly in exchange for money or property or as pay for services provided to the corporation. (Not by buying the QSBS from an initial holder.)
For Stock acquired after September 27, 2010 and held for more than 5 years there is no Federal tax on the gain.
It is free from:
alternative minimum tax (AMT), and
Net Investment Income Tax (NIIT) imposed by section 1411 of the Internal Revenue Code.
If it’s held for more than 1 year but not more than 5 years, the gain is treated like any other capital gain.
If the stock is held for 1 year or less, the gain is a short-term capital gain.
The excludable gain is limited to the greater of $10 million or 10 times the adjusted basis of the investment.
If the holding period for the optimum exclusion is not met, gain can be deferred by reinvesting proceeds in stock of another QSB within 60 days of the sale. To use this deferral option, the stock merely had to be owned for more than six months.
Strategies for utilizing QSBS A. Attracting investors and Raising capital
The tax exclusion only applies to individuals. The stock can be acquired by a partnership so that a partner (who is an individual and not a corporation) can use the exclusion as long as he or she was a partner when the stock was purchased and at all times thereafter. The exclusion is limited to the partner’s percentage interest in the partnership at the time the stock was acquired.
B. Short Term and Incentive Comp for Employees
It is allowable to issue QSBS in exchange for services so it can be a useful tool for startups to compensate and incentivize their employees. When issuing QSBS that does not have any restrictions, there are still payroll tax costs to the company. The value of the stock, which is equal to the compensation that would have been paid instead for the services performed, is taxable compensation to the employees.
It is subject to income tax withholding, Social Security and Medicare (FICA) taxes, and FUTA (federal unemployment) tax. The withholding must be paid in cash, which usually is taken from other cash wages (it can be paid separately by the employee or by the company as additional compensation subject to additional payroll taxes).
Income tax withholding for the stock can be done in either of 2 ways:
Add the value of the stock to regular salary or wages and figure withholding in the usual way on the total amount, or
Withhold 25% of the value of the stock up to $1 million, 39.6% over $1 million.
Please contact us at Middle Market Advisory LLC if you require assistance with tax strategy and planning: info@MiddleMarketAdvisory.com
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