Qualified Small Business Stock – Navigating Potential Traps and Ways Around Them

The Qualified Small Business Stock (QSBS) exemption is an often misunderstood and under-utilized gem in the tax law.

Essentially, if a taxpayer sells QSBS, up to 100% of the gain can be excluded from federal (and sometimes state) income taxation. Because of the misconceptions often associated with QSBS, even when business owners are aware of the exclusion, they or their company may take actions that, while seemingly benign, unintentionally disqualify the stock from QSBS treatment. This article will explore a few potential traps and make some suggestions to avoid those traps.

The S Corporation Trap

Only investments made directly in a domestic C corporation will qualify for QSBS treatment. Therefore, any original investment in a corporation that was an S corporation at the time of the investment will not qualify for QSBS treatment. The following examples illustrate this potential trap:

  • Taxpayer forms and funds a Delaware corporation on February 1st. She is then advised that in order to claim the company’s start-up research and development (R&D) losses on her personal tax return, the company must be a pass-through entity for income tax purposes. In early April, she files an S corporation election statement, giving the company pass-through status. She is further advised that since her investment was in a C corporation and she did not elect S corporation status until April, the stock qualifies for QSBS treatment. However, the S election is retroactive to the February 1st formation date for tax purposes and as a result the stock will not qualify for QSBS treatment.
  • Taxpayer founded an S corporation and has operated it for two years. To facilitate the raising of capital, Taxpayer decides to convert the company to a C corporation. He is advised that this conversion will qualify the stock as QSBS. This advice may or may not be correct depending on the facts. If Taxpayer contributes the stock to a newly formed C corporation, the QSBS tests for the new company are determined on that date. However, if the simpler legal approach is taken and Taxpayer just revokes the S election, the original investment remains in the S corporation and the conversion cannot remove that taint for purposes of qualifying for QSBS treatment.

LLCs and Partnerships

Since the QSBS rules require a direct investment in a C corporation, LLCs and partnerships are potentially problematic as well. The following examples illustrate this potential trap:

  • A group of founders fund the early R&D expenses of the business and for similar reasons to the S corporation election in the first example above, the company is formed as an LLC so these R&D losses pass through to the founders and can be claimed on the founders’ personal tax returns. At a later date the company converts to a C corporation in order to raise outside financing. In this case, successful transformation to a C corporation that is eligible for QSBS treatment can be accomplished. The founders can form a new C corporation and contribute all of the equity of the existing LLC to the C corporation in exchange for C corporation stock. The founders will qualify for QSBS treatment because they received their stock directly from the C corporation.
  • If the facts are the same as above but instead the preferred method to create the C corporation is a legal reorganization under state law (which may be necessary for non-tax reasons) rather than the formation of a new C corporation, advisors must be sure that such approach will be treated for tax purposes as a contribution of LLC equity by the LLC owners to the C corporation in exchange for C corporation stock. If instead, the tax treatment of the conversion is a contribution of the LLC assets to the new C corporation in exchange for C corporation stock and an immediate distribution of that stock to the original LLC owners, the stock will not meet the QSBS requirements. The LLC owners will not get QSBS treatment because they did not receive their stock directly from the C corporation.

Redemptions

For various reasons, companies are sometimes founded by individuals who do not stay with the company for very long. Depending on how these individuals leave, their exit can actually cause QSBS treatment to be disallowed for the other investors. The rules state that if a company redeems stock, that redemption could retroactively disqualify other individuals’ investments within a window of two years before and two years after the redemption date. The following example illustrates this potential pitfall:

  • Individuals A and B found Company. Within six months of founding, B decides to exit. During this time and over the next six months before B actually leaves, Company raises money from investors and some of the proceeds are used to completely redeem B. As a result of this redemption, neither A’s founder shares nor the new investors’ shares qualify for the QSBS exemption. Under this fact pattern, even stock grants to new employees can be disqualified. Given these harsh results, it is imperative that companies understand these rules when a founder exits.

Personal Trap: Giving QSBS Stock to Charity

While this particular issue does not directly impact QSBS treatment, it can lead to tax inefficiencies with respect to QSBS shareholders. Generally speaking, when taxpayers are well advised regarding charitable giving, they know that giving appreciated stock to charity is more tax efficient than giving cash. For example, assume a taxpayer has $100 of zero basis, publicly traded stock. If she sold it and gave away the cash, she would have $100 of gain and offsetting $100 of charitable deduction, which is a good answer but not optimal (and depending on state rules could create additional tax). Instead, if she simply gave the stock to charity, she would still recognize the $100 charitable deduction but not create additional income allowing that $100 charitable deduction to offset other income. The inefficiency here is giving away QSBS stock where your gain will be excluded. Instead, the taxpayer would be better off selling the QSBS and giving away other, highly appreciated long-term (held for over a year) capital gain stock.

Contributing QSBS to a Family Partnership

As entrepreneurs and their families become more successful, it has become common practice to form Family Investment Companies (FICs) to consolidate family investment activity and use these FICs as wealth transfer vehicles. While there are many tax and non-tax advantages to these entities, there is also a danger. While it is perfectly permissible to gift QSBS during life or bequeath it at death (as authorized by the statute), a taxpayer may not contribute QSBS to a partnership without disqualifying the stock as QSBS. Under the rules, a taxpayer must make a direct investment in a qualified C corporation in exchange for that company’s stock. As soon as the FIC receives that transfer, the owner (now the FIC) and the direct investor are no long the same taxpayer. As a result, the stock is no longer QSBS. Once an individual owns QSBS he should never contribute it to a partnership. If it is desirable for the FIC to own QSBS, the entity must make the company investment directly. If structured correctly, the FIC can then sell the stock with no gain being allocated to the FIC owners. Alternatively, the FIC can distribute the QSBS to the owners and it will generally retain its characteristics as QSBS stock in their hands.

The QSBS exemption can be a very powerful tool for a small business and its owners. However, careful consideration must be given to the QSBS rules or taxpayers and their advisors may find they have derailed what can be enormous tax benefits.