We regularly receive questions from clients about qualified small business (“QSB”) stock. Some of our startup or early-stage clients encounter QSB stock in the context of an equity financing when investors request QSB stock representations and warranties in a stock purchase agreement. The National Venture Capital Association model stock purchase agreement, which is widely referenced and often serves as the basis for venture-backed financings, includes an optional QSB stock representation and warranty. Other clients encounter QSB stock in connection with a proposed acquisition and must determine the structure of the transaction and the tax treatment to selling shareholders. The purpose of this Practice Brief is to answer the most common questions we receive and provide a primer on QSB stock.
What is QSB stock?
QSB stock, also known as Section 1202 stock, is stock in a U.S. C corporation that meets the specific requirements of Section 1202 of the Internal Revenue Code of 1986, as amended.
How do you know if you have QSB stock?
In order to qualify as QSB stock, certain conditions must be satisfied. Some of the conditions are facts that will be generally known only or best by the issuing corporation and others are specific to each shareholder.
Specifically, in order to qualify as QSB stock, stock must be (1) stock of a QSB; (2) acquired by a noncorporate taxpayer either directly from the corporation or via gift, death, or a distribution from an entity taxed as a partnership in whose hands it was QSB stock; (3) issued after August 10, 1993; and (4) issued by the corporation, directly or through an underwriter, either (A) in exchange for money or other property (not including stock) or (B) as compensation for services provided to the corporation (other than services performed as an underwriter of such stock), e.g., restricted stock.
In order to be a QSB, a corporation must (1) have $50,000,000 or less in aggregate gross assets (both immediately before and immediately after the issuance of the stock in question); and (2) during substantially all of the investor’s holding period of the stock, (A) be an actively operating C corporation, and (B) use at least 80% (by value) of its assets in the active conduct of one or more “qualified” trades or businesses. A “qualified” trade or business is any business other than personal service businesses (i.e., any business in which its principal asset is the reputation or skill of one or more of its employees); banking, insurance, financing, leasing, investing or similar businesses; farming or mineral extraction businesses; and hotels, motels, restaurants or similar businesses. The stock of service corporations in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services and brokerage services will not qualify.
What are the tax benefits of QSB Stock?
Under Section 1202 a portion of the gain realized by a noncorporate taxpayer on the sale or other disposition of QSB stock held for more than five years is not subject to federal income tax. Subject to the limitations in the paragraph below, for QSB stock acquired on or after (1) September 28, 2010, 100% of the gain is not subject to federal income tax; (2) February 18, 2009 through September 27, 2010, 75% of the gain is not subject to federal income tax; and (3) August 11, 1993 through February 17, 2009, 50% of the gain is not subject to federal income tax. Note, however, that for QSB stock not subject to the 100% exclusion rate, special rules could apply to impact the tax treatment with respect to the taxable portion of the disposition and investors should consult their personal tax advisors about the application and impact of such rules.
An investor’s gains eligible for a QSB exclusion are limited to the greater of (1) 10 times the investor’s adjusted basis in the QSB stock (excluding any basis increases after the issuance date) or (2) $10,000,000 for each QSB. For purposes of these basis limitations, the basis of QSB stock issued in exchange for property contributed to the issuing corporation will be no less than the property’s fair market value as of the contribution date. For married individuals filing separately, the $10,000,000 limit on eligible gain is reduced to $5,000,000 for each spouse.
In addition to the federal income tax treatment described above, gains on QSB stock can have state and local tax consequences. Some states do not recognize the QSB exclusion rules and impose income tax on their residents’ full gains on QSB stock. Other states, such as North Carolina historically, more closely follow the federal rules, so that the amount of QSB stock gain excluded from federal tax is also excluded from the state’s income tax. Investors should consult their personal tax advisors about the applicable state and local taxation on their QSB stock gains.
If you have questions about QSB stock, consult your accountant or other tax advisors. In the context of a sale of a business involving or potentially involving QSB stock, consult your tax and legal advisors early in the process to allow for transaction structure analysis and planning.
Christie A. Hartinger is an attorney in the M&A Practice Group of Wyrick Robbins Yates & Ponton LLP, which represents clients across a broad range of industries in connection with their significant corporate transactions. The group publishes Practice Briefs periodically as a service to clients and friends. Adam B. Snyder is an attorney in the Tax Practice Group of Wyrick Robbins Yates & Ponton LLP, which provides a full range of services related to federal, state, and local taxation. The purpose of this Practice Brief is to provide general information, and it is not intended to provide, and should not be relied upon as, legal advice.