Thanks to the Protecting Americans from Tax Hikes (PATH) Act of 2015, the 0% rate on QSBS gains is now permanent. But you must own the QSBS for over five years and not all shares will qualify for the 0% rate. Here are some key points to help determine whether this tax break could work for you.
The Basics
QSBS is stock in a C corporation that meets the definition of a qualified small business corporation (QSBC). In general, QSBCs are the same as garden-variety C corporations for all tax and legal purposes. The only exception is that QSBS is eligible for favorable federal income tax treatment when it's sold.
The following requirements must be met for shares to be QSBS:
- The shares must be acquired after August 10, 1993, and they generally must be acquired upon original issuance or by gift or inheritance.
- The issuing corporation must be a QSBC at the date of the stock issuance and during substantially all the time you hold the shares.
- The issuing corporation's gross assets can't exceed $50 million at all times on or after August 10, 1993, and before the stock is issued — and immediately after the stock is issued. If, after the stock is issued, the corporation grows and exceeds the $50 million threshold, it won't lose its QSBC status for that reason.
- The issuing corporation must actively conduct a qualified business. Qualified businesses don't include: 1) service providers in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services and other businesses where the principal asset is the reputation or skill of employees; 2) banking, insurance, leasing, financing, investing or similar activities; 3) farming; 4) production or extraction of oil, natural gas or other minerals for which percentage depletion deductions are allowed; or 5) the operation of a hotel, motel, restaurant or similar business.
Important note. Before concluding that you're investing in a QSBC, consult your tax advisor. We have summarized the most important QSBC eligibility rules here, but there are more.
Tax-Free Rollovers of QSBS
In addition to the qualified small business stock (QSBS) gain exclusion breaks explained in the main article, there's also a tax-free gain rollover break. Under the rollover deal, the amount of QSBS gain that you must recognize for federal income tax purposes is limited to the excess of the QSBS sales proceeds over the amount that you reinvest to acquire other QSBS during a 60-day period. The reinvestment period begins on the date of the original sale.
You must hold QSBS for over six months to qualify for the rollover deal. The rolled-over gain reduces the basis of the replacement QSBS.
In essence, the rollover deal allows you to sell your original QSBS without owing any federal income tax. With a rollover, you also won't lose eligibility for the gain exclusion break when you eventually sell the replacement QSBS.
Timing Issues
The acquisition date for QSBS is critical to determine how much of the gain can be excluded (ignored for federal income tax purposes) when the shares are sold. The 0% tax rate — which equates to a 100% gain exclusion — is only available for sales of QSBC shares that are acquired on or after September 28, 2010.
For QSBC shares acquired between February 18, 2009, and September 27, 2010, you can potentially exclude (pay no federal income tax on) up to 75% of the otherwise-taxable gain.
For QSBC shares acquired after August 10, 1993, and before February 18, 2009, you can potentially exclude up to 50% of the otherwise-taxable gain.
Important note. These gain exclusions aren't available for QSBS owned by C corporations. However, shares held by individuals, S corporations and partnerships are potentially eligible.
In order to take advantage of the gain exclusions, you must hold the QSBS for over five years. So for shares that haven't been issued yet, the 0% tax rate will only be available for sales that occur sometime in 2021 at the earliest.
Limitations on Excludable Gains
Here's where things get complicated. Congress placed limits on the amount of QSBS gain that's eligible for the aforementioned exclusions. In any tax year, your eligible gain — the amount of gain that qualifies for the applicable gain exclusion percentage of 100%, 75% or 50% — is limited to the greater of:
- Ten times your aggregate adjusted basis in the QSBS that's sold, or
- $10 million (or $5 million if you're married but filed separately) reduced by the amount of eligible gain already taken into account by you in prior tax years for sales of QSBS issued by the same corporation. In effect, the $10 million (or $5 million) restriction is a lifetime limitation.
Tax Rates on Taxable Portions of Gains
The amount of eligible gain that you can't exclude — 25% or 50% of the total eligible gain, depending on when you acquired the shares — is subject to a 28% maximum federal income tax rate. That translates into an effective maximum rate on eligible gains of either 0% if the 100% gain exclusion applies, or 7% if the 75% exclusion applies, or 14% if the 50% exclusion applies. You may also owe the 3.8% net investment income tax (NIIT) on eligible gains that you can't completely exclude.
Any gain in excess of the eligible gain amount is taxed as a regular stock sale gain. A 20% maximum federal rate applies to excess gains that are recognized in 2016. You may also owe the 3.8% NIIT.
Business Structure Matters
Conventional tax-planning wisdom might lead you to believe that every start-up or closely held business should operate as a pass-through entity, such as an S corporation, partnership or limited liability company. But that assumption could be flawed if your business meets the definition of a QSBC, due to the gain exclusion breaks offered to QSBS owners. Consult your tax advisor for full details before starting up or investing in a new business.