Business Option Small Stock
Employees of privately-held corporations can elect to defer income for up to 5 years on the value of stock acquired by exercising qualified stock options and RSUs granted to them by their employers. Let me give you an example of how all of the possible taxation rules apply:
business option small stock
Small business ideas, business tax news and small business consulting from Barbara Weltman to provide business owners with the information they need to succeed. Visit our small business blog, Idea of The Day, small business books and articles on small business taxes, small business finance and small business legal advice.
Founders and early employees of startups have an opportunity for huge tax savings. It is possible to exempt the greater of 10M in capital gains or 10x the invested capital from federal taxes if the investment (exercising stock options counts as investing) is held at least 5 years.
This is possible due to an exemption in the tax code called Qualified Small Business Stock of QSBS. Basically, if you exercise stock options in a company worth less than $50M and hold the stock for 5 or more years, you can exempt up to $10M in capital gains. Meaning you likely won't owe any taxes when you eventually sell the stock!
Qualified Small Business Stock (QSBS) is part of the federal government's Internal Revenue Code (section 1202). A company qualifies as a small business if it is a US based C corporation that has less than $50M in assets. Some sectors of companies do not qualify for QSBS such as hotels, banks, farms and more.
The rules applying to QSBS were designed to encourage investments in certain small businesses; however, the exemption does not apply to California income taxes post 2012. Some entrepreneurs contemplate leaving California before their M&A or IPOs are completed, but be warned, as this must be a bona fide intention to move and is subject to audit for at least 3 years. Other states should be reviewed on a case by case basis.
If the holding period for the optimum exclusion is not met, gain can be deferred by reinvesting proceeds in stock of another qualified small business within 60 days of the sale. To use this deferral option, the stock merely had to be owned for more than six months.
If you have a C corporation or are thinking of forming one and you are in an eligible industry described earlier, consider using qualified small business stock to raise capital or compensate key employees. Talk to a tax advisor to make sure that all conditions for being a qualified small business are met before you proceed.
In fact, many makers on Shopify started out with a home business idea, selling on Etsy or eBay, or to friends and family through word of mouth, and grew into full-time small-business owners after establishing demand for their products.
The key to making this a successful business idea is to offer the right products at the right location. Do your research to find high-trafficked areas and understand exactly who is walking by and what they might need at that moment. With a strategic approach, vending machines can be a profitable business idea with small investment and an overall great business idea.
With many of the small business ideas explored in this post, you may not be shipping your products, but you still need to cover the cost of shipping. Consider your shipping costs and how they will vary in the different countries you want to serve.
Sec. 1202(a) provides that a noncorporate shareholder can exclude 50% of the gain from the sale of qualified small business (QSB) stock that has been held for five years.3 QSB stock must be stock in a C corporation; thus, Sec. 1202 is generally not available to exclude gain on the sale of S corporation stock or a partnership interest.
Sec. 1202 was added to the Code as part of the Revenue Reconciliation Act of 1993,6 with the stated purpose of providing targeted relief for investors who risk their funds in new ventures and small businesses. At the time, long-term capital gain was taxed at the same rates that apply to ordinary income, subject to a maximum rate of 28%.
The committee reports to the Revenue Reconciliation Act of 1993 clarify that stock a shareholder acquired through the exercise of options or warrants or through the conversion of convertible debt is treated as acquired at original issuance.21
When stock is received by a shareholder upon the exercise of an option, warrant, or convertible debt, the issuance date is the date of exercise or conversion.26 An unexercised option or warrant is never considered QSB stock, even if the underlying stock would meet the definition of QSB stock in the hands of the option holder.27
To meet the definition of QSB stock, two requirements must be met for "substantially all" of the shareholder's holding period; specifically, the corporation must be a C corporation and satisfy the "active business" requirement. It is important to understand that these tests do not apply to the entire lifespan of the corporation but rather to the period of time that a shareholder attempting to qualify for the benefits of Sec. 1202 holds the corporation's stock. Thus, while these tests are measured at the corporate level, the period of time for which they are measured is determined at the shareholder level.
For stock in a corporation to meet the definition of QSB stock, during substantially all of the shareholder's holding period, the corporation must be an "eligible corporation," and at least 80% (by value) of the assets of the corporation must be used by the corporation in the active conduct of one or more "qualified trades or businesses."36
The primary motivation for Sec. 1202 is to encourage capital investment in small businesses; this is the very reason for the requirement that QSB stock be acquired by the shareholder at original issuance. In the absence of a safeguard, corporations could evade the requirement that QSB stock be newly issued stock by redeeming non-QSB stock from a shareholder only to reissue it as QSB stock. To prevent this result, the statute provides two restrictions governing redemptions.
Thus, if the high-income owner of a service business who would be denied a deduction under Sec. 199A opts instead to operate as a C corporation, no Sec. 1202 exclusion will be available upon a future sale of the corporation's stock.
As discussed earlier in this article, for stock to meet the definition of QSB stock, the issuing corporation must be a C corporation on the date of issuance. Thus, if an S corporation that otherwise meets all the requirements of a qualified small business under Sec. 1202 issues stock, that stock can never qualify as QSB stock, even if the S corporation later converts to a C corporation.
The confluence of a 21% corporate rate and the 100% Sec. 1202 exclusion could well usher in a golden era of C corporations. All tax and nontax factors must be taken into consideration, but once the decision has been made to operate as a C corporation, business owners and their tax advisers will need to be proactive in taking the steps necessary to ensure the stock meets the definition of QSB stock; from testing the gross adjusted basis of assets upon the issuance of shares, to valuing, measuring, and documenting the value of assets annually for purposes of the active business requirement, to analyzing the effect of any corporate redemptions.
27Id. Because of this rule, if a corporation is a target in a tax-free reorganization, a taxpayer who owns an option to acquire stock in the target corporation that would qualify as QSB stock (without regard to the five-year holding period) should consider exercising the option prior to the transaction so that the stock received in the transaction will also qualify as QSB stock. See the discussion in the article concerning an exchange of QSB stock in a reorganization.
36Sec. 1202(e)(1). This requirement is waived for a corporation that is a specialized small business investment company (SSBIC). An SSBIC is any eligible corporation (under the meaning of Sec. 1202(e)(4)) that is licensed to operate under Section 301(d) of the Small Business Investment Act of 1957 (as in effect on May 13, 1993). See Sec. 1202(c)(2)(B).
If you invested in a startup or small business (founders, employee exercise of stock options, business owner), you need to know about qualified small business stock. If eligible, you may be able to exclude up to 100% of the gain from federal taxes when you sell your shares. Qualified small business stock (also called QSBS or Section 1202) has the potential to save millions (even tens of millions) in taxes. But before you can claim a gain exclusion, you must understand eligibility requirements and be able to support the claim.
Using IRS Section 1202, taxpayers can sell stock potentially free of federal capital gains taxes if the requirements are met. This article is meant to be an easily-digestible introduction to qualified small business stock. It is not personal legal/tax/financial advice or an exhaustive discussion of QSBS.
Always aim for sign-off from the company (consider a checklist, even annually) asserting the relevant facts (gross assets at issue, significant redemptions, engaging in qualified trade/business, etc.). Gather your own records of stock purchases/exercises, redemptions, cost basis, gifts/transfers, and so on for safe keeping.
As evidenced by the length of this summary on qualified small business stock, the subject matter is complex. You may never have QSBS, and if you do, you may not be fortunate enough to qualify more than once. Strongly consider engaging a personal team of tax and financial advisors to help guide you through the process.
Option grants are even more controversial for many outside observers. The grants seem to shower ever greater riches on top executives, with little connection to corporate performance. They appear to offer great upside rewards with little downside risk. And, according to some very vocal critics, they motivate corporate leaders to pursue short-term moves that provide immediate boosts to stock values rather than build companies that will thrive over the long run. As the use of stock options has begun to expand internationally, such concerns have spread from the United States to the business centers of Europe and Asia. 041b061a72
