Emerging Markets Law

Qualified Small Business Stock

Entrepreneurs and angel investors often ask whether an investment in a particular start-up will qualify as “qualified small business stock” for purposes of Section 1202 of the Internal Revenue Code (the “IRC”). 

IRC Section 1202 creates a powerful incentive for investors to invest in qualified small business stock. If all the requirements of Section 1202 apply, an investor may exclude from income between 50% and 100% of the gain the investor realizes upon a qualifying sale of that small business stock that the investor has held for five years or more. In other words, under some circumstances, the investor’s gain can be tax-free!

There are two main concepts investors should keep in mind when investing in a start-up with the hope of getting “qualified small business stock” (“QSB” stock). The first is that the start-up must satisfy the requirements for being a QSB. The second is that the investor’s investment in, and eventual sale of, the stock must also satisfy several requirements.

Company Requirements

IRC Section 1202 provides that stock can be QSB stock if:

  • The company is organized as a subchapter-C corporation;
  • The stock was originally issued after August 10, 1993; and
  • As of the date the stock was issued, the corporation had total gross assets of $50 million or less (a) at all times after August 9, 1993, and before the stock was issued, and (b) immediately after the stock was issued. (Note that “gross assets” include those of any predecessor of the corporation and all corporations that are members of the same parent-subsidiary controlled group are treated as one corporation.)

Importantly, start-ups that are structured as limited liability companies (taxed as a partnership) will not qualify and corporations taxed under subchapter-S will also not qualify.

Investor Purchase and Sale Requirements

To ensure that the investor’s purchase and sale of QSB stock qualifies the investor for the income exclusion:

  • The investor must have acquired the stock at its original issue (either directly or through an underwriter), either in exchange for money or other property (other than stock) or as pay for services (other than as an underwriter) to the corporation. (IRS regulations sometimes permit investors to acquire QSB stock from another person who met the test (such as by gift or inheritance) or through a conversion or exchange of QSB stock.)
  • In addition, during substantially all the time the investor held the stock (a) the corporation must have continued to be a subchapter-C corporation, and (b) at least 80% of the value of the corporation's assets must have been used in the active conduct of one or more qualified businesses, and (c) the corporation must not have been a foreign corporation, DISC, former DISC, regulated investment company, real estate investment trust, REMIC, FASIT, a cooperative, or a corporation that has made (or that has a subsidiary that has made) an IRC Section 936 election
  • For purposes of the “qualified business” test, the corporation must have been engaged in a trade or business other than: (A) any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees, (B) any banking, insurance, financing, leasing, investing, or similar business, (C) any farming business (including the business of raising or harvesting trees), (D) any business involving the production or extraction of products of a character with respect to which a deduction is allowable under section 613 or 613A, and (E) any business of operating a hotel, motel, restaurant, or similar business.

Limitations on the Exclusion of Gain

Investors shall also be aware that the exclusion from income under Section 1202 is not an unlimited exclusion. The amount of gain that may be excluded in any taxable year is capped at an amount equal to the greater of (A) $10,000,000 reduced by the aggregate amount of eligible gain taken into account by the taxpayer under Section 1202 for prior taxable years and attributable to dispositions of stock issued by such corporation, or (B) 10 times the aggregate adjusted bases of qualified small business stock issued by such corporation and disposed of by the taxpayer during the taxable year.

Because the QSB rules are complicated and depend in part on circumstances that are unique to each investor, start-ups and entrepreneurs should be especially careful when pitching the benefits of QSB treatment to their potential investors.

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