QSBS: Sell Your Business and Potentially Pay Less Tax

Let’s flash back to 1993. Bill Clinton became the 42nd President of the United States. Mariah Carey, Whitney Houston, Meat Loaf and UB40 dominated the billboard music charts. Hocus Pocus debuted in July instead of October, as Disney didn’t want to compete against their other Halloween-themed film, The Nightmare before Christmas, which was due for release in October. Section 1202 was added to the Internal Revenue Code as part of the Revenue Reconciliation Act to entice taxpayers to invest in small businesses.¹

Admittedly, that last part about the tax code may not be as fun as those other highlights, but if you’re a small business owner, the legislation introduced in 1993 could shelter you from a large amount of taxes.²

For example, Section 1202 allows stockholders to exclude $10 million of federal capital gains from taxation through the sale of qualified small business stock (QSBS) that had been issued after September 27, 2010.³ Let’s put some numbers around this. Assuming a top federal capital gains rate of 23.8% (which includes the 3.8% net investment income tax), stockholders selling $10 million worth of QSBS qualify for a $2.38 million gain exclusion. Those are dollars you can keep in your pocket to potentially further your goals in your financial plan.

You may be asking yourself if this legislation is here to stay—and historically, you would’ve been wise to ask. Congress used to vote each year on whether this piece of the tax code would remain. That changed in 2015 when President Obama signed the Protecting Americans from Tax Hikes (PATH) Act. This legislation made the provision “permanent,” so it looks like QSBS will be here to stay for some time.

What is a qualified small business?

While you might like the idea of saving taxes, how do you know if you qualify for this tax break? A qualified small business (QSB) is defined by the Internal Revenue Service as an active domestic C corporation⁴ whose gross assets—valued at the original cost—do not exceed $50 million on or immediately after its stock issuance.⁵ The investor must have held their stock for at least five years, and 80% of the assets must be used to conduct one or more qualified trades or businesses.

That leads to the next question: “What’s a qualified trade or business?” Only certain types of companies fall under the category of a QSB, and it’s worth checking with your legal and accounting professionals to see if you qualify. As a general guideline, firms in the technology, retail, wholesale and manufacturing sectors are eligible as QSBs, while those in the hospitality industry, personal services, the financial sector, farming and mining are not.⁶

How do you use your QSBS?

The tax treatment for a QSBS depends on when the stock was acquired. As an example, for qualifying stock acquired after September 27, 2010, the exclusion percentage is 100%. If you acquired your stock prior to that date, your exclusion percentage is a smaller number. ⁷

In addition, under Section 1202, the federal capital gains exclusion is limited to $10 million or 10 times the adjusted cost basis of the QSBS, whichever is greater.⁸

Example: The QSBS multiplier effect

Let’s say you held original-issue QSB founder stock from 2015 with a cost basis of one penny. The company was sold in 2024 and your shares were valued at $50 million. We’ll assume $10 million of the QSBS was cashed out in the deal and $40 million in acquirer stock of the new company was received (with carryover QSBS basis). Since those shares were issued after September 27, 2010, 100% of the capital gain on the first $10 million in cash is excluded from taxation that tax year.

You now have $40 million in carryover QSBS with which to strategize. If this remaining QSB stock is then made by completed gift to multiple “taxpayers,” they can each receive a separate $10 million capital gains exclusion. Hence, the term “QSBS multiplier effect,” as a $10 million benefit is multiplied into a $50 million tax benefit.

As a QSB founder stock owner, you may complete gift transfers in different ways to avoid taxation. Here are three examples for gifting your $40 million carryover QSBS:

1. Make a completed gift transfer of $10 million to irrevocable trusts for each of your children (in this example, two children), who in turn would each receive the $10 million capital gains tax exclusion upon the future sale of this stock.
2. Gift $10 million to a Charitable Remainder Trust (CRT) that, along with receiving a partial tax deduction for contribution, may also receive an exclusion of capital gains income upon future CRT quarterly income distributions.
3. Gift the last $10 million to a non-grantor trust domiciled in a zero-income tax state. The future stock sale could be free of income taxation at the federal and state levels, and may also provide asset protection measures.

What if you don’t have five years before your exit?

Business owners who want to sell QSBS that has not been held for the minimum five years may leverage Section 1045 of the Internal Revenue Code. This provision in the tax code allows them to defer the gain by reinvesting the proceeds from the sale of that QSBS, provided that these shares have been held by the taxpayer for more than six months, into another QSBS within 60 days.⁹

The bottom line

You’ve likely worked extremely hard over the years building your business. QSBS is another tool to help keep more dollars in your pocket that otherwise would go to the government in the form of capital gains tax. Although the above information is helpful, it doesn’t cover all the nuances behind this complex piece of tax code. We strongly encourage you to work with your Corient Wealth Advisor, attorney and tax professional to determine whether the sale of QSBS is the right solution for your business and personal planning.

¹ https://www.investopedia.com/terms/q/qsbs-qualified-small-business-stock.asp#:~:text=Section%201202%20of%20the%20IRC,the%20gain%20can%20be%20excluded
² https://www.investopedia.com/terms/s/section-1202.asp
³ https://www.thetaxadviser.com/issues/2024/apr/qualified-small-business-stock-gray-areas-in-estate-planning.html
⁴ https://www.investopedia.com/terms/c/c-corporation.asp
⁵ https://www.investopedia.com/terms/q/qsbs-qualified-small-business-stock.asp
⁶ https://www.investopedia.com/terms/q/qsbs-qualified-small-business-stock.asp
⁷ https://www.investopedia.com/terms/q/qsbs-qualified-small-business-stock.asp
⁸ https://www.govinfo.gov/content/pkg/USCODE-2011-title26/pdf/USCODE-2011-title26-subtitleA-chap1-subchapP-partI-sec1202.pdf
⁹ https://www.irs.gov/pub/irs-drop/rp98-48.pdf

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