As a business owner, there is always something that you’re thinking about. Whether it’s paying employees, scaling, filing taxes, or creating growth plans, there is an endless to-do list of tasks that can move your business forward.
In our recent planning opportunities with new clients, we’ve seen that many business owners have had the opportunity to sell their businesses but leave money on the table because of the lack of planning and strategy. To ensure that this doesn’t happen to you, in this blog we’ll discuss the Qualified Sale of Business Stock exemption.
QSBS stands for qualified sale of business stock. As outlined in section 1202 of the tax code, this rule was created to encourage the growth and investment into small businesses in America. By using the QSBS exemption, shareholders - if qualified - can save up to ten million dollars in federal income taxes.
As a business owner, there are three ways for you to qualify for the QSBS exemption:
If your business is structured as a s-corporation or limited liability company you will not be able to qualify.
You have to hold shares of the c-corporation for at least 5 years to be able to qualify for the company. This means if you obtained your shares on Jan 1, 2023, you wouldn’t be eligible for QSBS until January 1, 2028.
In some cases with private companies, investors will sell their shares to one another. If you plan on using section 1202, you have to obtain the shares directly from the company. This means that the company must issue the shares directly to you.
If you meet these requirements as a founder, you’ll qualify for the exemption. Yet, the second layer of qualification deals with your business meeting the requirements. To make sure that your business qualifies, it must:
As section 1202 suggests, this hack was made for small businesses. In the eyes of the United States government, any business that has assets under 50 million in value is considered small. For your business to qualify, your balance sheet must reflect that your asset value is under the 50 million dollar threshold.
It’s very common for larger corporations to spin off parts of their business. Unfortunately, if you'd like to apply the QSBS exemption, the potential buyer would assume ownership of the business by purchasing the shares and not the assets. To qualify, you have to ensure that the acquisition of your company comes in the form of a stock transaction.
Unfortunately, some industries are excluded from the section 1202 exemption. These industries are:
If you operate a business in one of these industries, you will not be able to apply the QSBS exemption to your sale, but there are planning alternatives that will still allow you to save money on your taxable gains.
Before you utilize the QSBS exemption, the steps listed above are imperative to ensure that you’ve done the due diligence and can successfully pass an IRS audit. Due to the likelihood of an audit being high after applying QSBS benefit, gaining an opinion letter or letter of attestation from a law firm is a prudent step.
Additionally, you should pay special attention to tax form 8949 as you will need to document the transaction of the sale of your shares on this form. Specifically, the form will ask for:
For example, if you acquired your shares on January 15th, 2016 for $1,000 and you sold your company for $900,000 on November 20, 2023 you would qualify for the QSBS exemption because more than 5 years have passed since obtaining the stock.
Assuming that you’ve obtaining a letter of attestation from a law firm, you would code tax form 8949 as “Q” which stands for qualified sale of business stock, you would enter the acquisition and sale dates - January 15th, 2016 and November 20, 2023, respectfully - you’d list the cost basis ($1,000), the sale price ($900,000) and the difference between them which is $899,000. The amount of the difference is the amount that you are exempt from paying federal taxes on.
It is important to note that state taxes will still apply in California, but the savings are tremendous if you structure this early, and document everything along the way. If you are planning to secure your retirement through a sale of a business, be sure to schedule your introductory call with us so that we can assist you.
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