What Investors Should Know About Qualified Small Business Stock
Nathan J. Neuberger
Shareholder
Reinhart Boerner Van Deuren
nneuberger@reinhartlaw.com
Nate Neuberger represents private equity firms in a wide range of transactions including leveraged buyouts, strategic mergers and acquisitions, corporate governance and financing. He specializes in deals with transaction values between $10 million and $250 million. In this guest article, Nate explains how QSBS can be a significant benefit to investors in lower-middle market companies. This article is intended to provide only a general summary of the QSBS benefit and its requirements. Code Section 1202 contains numerous technical rules that must be satisfied for an investment to qualify as QSBS. We recommend contacting a tax advisor before assuming any investment qualifies as QSBS.
The U.S federal tax code provides a significant benefit to individuals who make a qualifying investment in Qualified Small Business Stock (QSBS). If properly structured, QSBS can be a significant benefit to investors in lower middle-market companies by significantly reducing or fully eliminating an investor’s income taxes upon sale of the investment.
The tax benefit for QSBS under Code Section 1202 has been in existence since 1993. However, the benefit was significantly enhanced by Congress in the early 2010s. Moreover, the 2017 Tax Cuts and Jobs Act reduced the federal C corporation income tax rate from 35% to 21%, which made it less punitive for businesses to organize as C corporations. These changes made the QSBS benefit significantly more valuable, and we have seen a proliferation of private equity and venture capital investors seeking to take advantage of QSBS in the past several years.
To qualify for the QSBS tax benefit, an individual investor must make an investment in newly issued stock of a C corporation at a time when the corporation has a gross asset value of less than $50 million. The QSBS must be held by the investor for at least five years before disposition. If all of the QSBS requirements are met, upon sale the investor’s capital gains tax rate will be reduced to 0%. Further, the 3.8% net investment income tax also will not apply. In some states, state income taxes may be avoided.
Individuals that invest through LLCs or other pass-through entities (for example, through a private equity fund) can also receive the tax benefit if the pass-through entity makes an investment in QSBS. Importantly, to qualify, the individual must be a member of the pass-through entity on the date on which the pass-through entity acquires the QSBS.
If an individual investor or pass-through entity invests in multiple rounds of C corporation stock over time, each of those rounds is independently tested for QSBS status. The five-year holding period for each successive round of QSBS starts to run on the date on which the investment round closes.
There are a number of limitations that apply to the QSBS benefit. For example, companies in certain industries (such as financial services, professional services, health or hospitality) are ineligible to issue QSBS. Further, the capital gain exclusion for an individual investor for any particular investment is generally limited to $10 million of gain or 10x the investment amount, whichever is greater. Certain actions by the company during the investment period (such as certain redemptions or excess passive investments) can also limit QSBS eligibility.
There is very little caselaw or IRS guidance to help interpret the QSBS requirements. Future cases, regulations or rulings could further limit the applicability of the QSBS benefit.
Many states provide tax exemptions similar to the federal QSBS exemption. For example, Wisconsin provides a 50% reduction in state income taxes for a QSBS sale. Wisconsin also provides a separate benefit for “Qualified Wisconsin Businesses” that is similar to QSBS, which can fully eliminate capital gains taxes for investments in certain Wisconsin-based businesses.