California Qualified Small Business Stock (QSBS) Tax Exemption
Having a qualified small business stock (QSBS) is a good option for those who own a California-based company, and want to make sure their assets and employees are primarily located in California. However, there are some requirements that you must meet in order to qualify for this tax break.
Can an LLC be a QSBS?
Whether you are a startup founder or a longtime investor, the QSBS tax exemption may be a valuable tax planning tool for you. The QSBS is an IRS tax code section that provides for 100% tax free capital gains on the sale of qualified small business stock. The QSBS tax exemption was originally introduced as a partial exclusion in 1993, but was expanded to 100% in 2010 as part of the Small Business Jobs Act.
The QSBS exemption is designed to motivate shareholders of small companies to invest. In turn, it helps to unlock equity and drive high growth potential for businesses. However, there are several guidelines for whether a particular company will qualify for the QSBS treatment. In addition to the legal structure of the business, these guidelines include whether the business is active and whether the business has more than 50 million in assets.
The first requirement for qualifying for the QSBS tax exemption is that the company has a minimum of five years of operation. This period of time must start after the company is incorporated or has issued its first shares. It cannot begin sooner than after the conversion of options and ISO/NSO splits. It is also possible to qualify for the QSBS tax exemption when the company is converted from an LLC to a C corporation. However, it is important to note that the startup must remain a C corporation until it is sold. While it is unlikely that the startup will be taxed for a long period of time, this structure may prevent the startup founder from taking advantage of many tax benefits.
The second requirement is that the issuing corporation must have no more than $50 million in gross assets. This limit applies to the corporation’s assets and the assets of any shareholder. If the corporation has more than $50 million in assets, the shareholder’s assets may not qualify for the QSBS tax exemption. The shareholder’s assets can qualify if they are transferred to another corporation, such as a trust or a partnership.
The third requirement is that the shares issued must qualify as QSBS. This is determined when the holder exercises the option to purchase the shares. The shares may be non-voting preferred stock or voting common stock. The shares may also be owned by partnerships or LLCs. The shares can be acquired through distributions or gifting.
In addition to the QSBS tax exemption, there are also many other tax savings opportunities available to entrepreneurs. If you are a startup founder, you should consider consulting a tax expert before making a major liquidity event such as a sale or conversion. While the QSBS tax exemption may be able to reduce your tax bill, it is also important to understand that not all states follow the federal tax code.
Estate and gift tax implications of pre-planning with QSBS
Investing in a company with qualified small business stock (QSBS) can be a good way to invest for both tax and estate planning purposes. However, there are some complexities to be aware of. Fortunately, you can get expert help in this area.
A QSBS can be defined as an investment made by a qualified small business or corporation that is eligible for deferred gain exclusion under Internal Revenue Code section 1202 (Section 1202), which limits the amount of gain that can be excluded in a given year. For the tax year in which you acquire your QSBS, you can exclude a portion of your gain, up to $10 million or ten times your basis, depending on your situation. If you sell your QSBS later, you may be able to roll your gain into another QSBS. This can help you to remove future appreciation from your estate. It may also be an opportunity for you to transfer your holding period to another qualified small business or corporation.
The benefit of QSBS is that it can be acquired through a gift or even death, providing you with a way to avoid federal income tax on gains. However, a gift may be subject to the estate and gift tax, which ranges from 18% to 40%. You can avoid this tax by acquiring QSBS stock from a qualified small business through a non-grantor trust. This type of trust offers the advantage of not being subject to state income tax and provides better asset protection than an individual trust.
Another way to acquire QSBS is to convert your LLC to a C corporation. This may be a smart choice if your state does not recognize non-grantor trusts. However, there are some rules that are specific to non-grantor trusts. These rules include sourcing rules and throwback provisions. You can also invest in a QSBS through a tax partnership. These types of entities can be beneficial if you own a business in a high tax state or are planning to move to a new state in the future.
For the estate and gift tax, it is important to note that the QSBS exclusion may not be as generous as it seems. This is because QSBS is only tax-deductible if it is held for at least five years. You may be able to take advantage of this benefit if you acquire your QSBS as a gift, if you are planning to move to a new state, or if you plan to convert your LLC to a C corporation later. However, if you do not meet the requirements, you may lose your QSBS exemption. If you are considering using a non-grantor trust to acquire QSBS, make sure you are working with an experienced tax advisor.
In the end, the QSBS exclusion can be an invaluable benefit for you. However, the rules are a little bit murky and there are still many questions to be answered. If you are interested in learning more about the benefits of QSBS, please visit our QSBS FAQ page.