When business owners and investors build a successful company, taxes are often a major consideration. And in the event of a major liquidity event, including a sale, reducing tax liability is critical.

However, reducing capital gains taxes and tax liability requires some foresight. And it’s incumbent upon all business owners and investors to fully think through how they can avoid onerous taxes in the event of a successful liquidity event.

One of the tools most often used by Perlson LLP professionals to aid clients in avoiding those issues is Qualified Small Business Stock, or Section 1202, the section in the Internal Revenue Code that governs it.

Unfortunately, QSBS, as it’s come to be known, is an obscure provision that too often, both CPAs and attorneys overlook when consulting clients on how to avoid high taxes. And by not taking advantage of its massive benefits, business owners stand to lose millions of dollars in taxes.

So, what is QSBS and how can it be used in your business? Read on to learn more. And as always, contact a Perlson LLP professional at 516-541-0022 to learn the ways in which we can implement QSBS for you and help you save on taxes.

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QSBS Basics

Qualified Small Business Stock is an effective tax-savings tool for the right company — and especially tech startups — that allows shareholders, including investors and entrepreneurs, to avoid paying taxes when they cash out of their investment.

Most importantly, QSBS can also provide a major savings: the QSBS allows qualifying taxpayers to reduce their capital gains tax by the greater of $10 million or 10 times the cost of their stock. Be aware, however, that the limitation is cumulative.

While QSBS is an extremely powerful tool, it’s also somewhat restrictive and requires companies to plan ahead to ensure they qualify for the opportunity to tax advantage of it.‍

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Who Qualifies for QSBS?‍

In order to qualify for the QSBS provision, an organization must be a C-Corporation. LLCs, sole proprietorships, or S-Corporations do not apply for the QSBS tax savings. And although companies currently structured as S-Corporations or LLCs can transfer to C-Corporations to qualify, the provision still requires that C-Corporation stock to be held for five years before the companies can qualify.

Indeed, the five-year lookback period is an important component in QSBS. The requirement essentially means that entrepreneurs and investors must have held the stock for the five-year period leading up to the liquidity event in order to qualify. Even if an S-Corporation that migrated to a C-Corporation has been in business for more than five years, the QSBS clock doesn’t start ticking until the C-Corporation shift has been made.

Additionally, QSBS only applies to stock issued after 1993, so older companies do not qualify. Stock must have also been an original issue and the company must not have more than $50 million in assets on the date the stock was issued to those hoping to take advantage of the QSBS.‍

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Limitations to Consider‍

As you might expect, there are some other limitations baked into the QSBS that you’ll need to keep in mind before you can use it to reduce your tax liability.

Chiefly, 80% of a company’s assets at the time of stock issuance must be used in active business operations. It’s also worth noting, however, that software development on a tool that would be used in the company’s operations, qualifies as part of the active business provision.‍

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Applying QSBS‍

In addition to some basic limitations, QSBS is applied based on a timetable dependent upon when the qualifying stock was acquired. For those who acquired the stock on or before February 17, 2009, a 50% exclusion on capital gains taxes is allowed. Those who received the stock between February 18, 2009 to September 27, 2010 can take a 75% exclusion. C-Corporation stock issued on September 28, 2010 or later qualifies for a 100% exclusion.

Again, the amount actually saved is limited to the greater of $10 million or 10 times the cost of the stock.