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The Tax Benefits of Investing in Small Businesses

The Qualified Small Business Stock exclusion is an extremely valuable incentive for entrepreneurs and investors.
The Tax Benefits of Investing in Small Businesses
Image credit: Getty Images
By BNY Mellon Wealth Management

OVERVIEW

Recognizing that small businesses drive the economy, produce jobs and lead innovation, Congress has enacted several laws over the years designed to encourage investments in small businesses. The Qualified Small Business Stock (QSBS) exclusion allows qualified investors to exclude a portion of gains from sales of QSBS if certain requirements are met, which can provide significant savings and ultimately increase the after-tax cash proceeds.

ANALYSIS                 

The QSBS exclusion allows investors to exclude up to 100% of their gain on the sale of QSBS (depending on the date the stock was acquired), capped at the greater of $10 million or 10 times the investor's tax basis in the stock.

1. Issuer must be engaged in a qualified trade or business.

The company issuing the stock must be a domestic C corporation, and must use at least 80 percent of its assets conducting a qualified trade or business. Financial and service-oriented businesses generally do not qualify.

2. Investor must acquire stock directly from the issuer.

To qualify for the QSBS exclusion, the investor cannot be a C corporation. In addition, the investor must have acquired the stock directly from the issuing company, not the secondary market.

3. There is a five-year holding period.

Investors must hold QSBS for at least five years to qualify for the exclusion, although exchanging stock in certain circumstances (e.g., a gift or inheritance, stock options) may also qualify.

4. No special tax filings are required.

When an investor's stock purchase and subsequent sale or exchange meet the requirements for the QSBS exclusion, the investor only needs to indicate on his or her tax return that transactions are eligible for the Section 1202 exclusion. It's important to remember, however, that not all states follow the federal tax treatment of QSBS.

KEY DATA

“The QSBS exclusion can also be a valuable incentive for small businesses raising money from outside investors... and for recruiting or rewarding key employees.”

DETERMINE THE EXCLUSION AMOUNT

The amount of capital gains that can be excluded depends on when the QSBS was acquired.

IMPLICATIONS

Understand the potential benefits and risks of the QSBS exclusion

Gifting or transferring QSBS may help maximize its impact

QSBS received as a gift or inheritance retains its qualified status, so using QSBS for lifetime gifting or transfers through trusts may increase tax savings.

Consider potential implications of business formation

Establishing a C corporation to qualify for the QSBS exclusion can have other tax implications beyond QSBS; another type of business entity may be more advantageous.

Coordinated planning is key

Before starting a business, making investments or selling stock, be proactive. Financial and tax professionals can help you decide if the QSBS exclusion is right for you.

For more BNY Mellon Wealth thought leadership read more here.

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