Tax Treatment for the Sale of Small Business Stock

The sale of small business stock can provide a tax benefit to investors, founders, and early employees. A provision in the tax code allows a portion, and sometimes all, of the capital gain from such a sale to be excluded from federal income tax. This incentive was designed to encourage investment in new ventures and growing companies. Understanding the rules is a prerequisite to benefiting from them, as the regulations contain detailed requirements that both the corporation and the shareholder must meet.

Qualifying for the Tax Exclusion

For a stock to be considered Qualified Small Business Stock (QSBS) and eligible for the gain exclusion under Section 1202 of the Internal Revenue Code, both the corporation and the shareholder must satisfy a series of tests. These requirements are distinct and must be met at specific points in time, from issuance to sale. Failure to meet any one of these conditions can disqualify the entire gain from this tax treatment.

The issuing entity must be a domestic C-corporation. This means other business structures, such as S-corporations or limited liability companies (LLCs) taxed as partnerships, do not issue qualifying stock. An LLC that elects to be taxed as a C-corporation can, however, issue eligible stock. This requirement must be met when the stock is issued and for substantially all of the shareholder’s holding period.

A corporate-level requirement is the gross assets test. At all times after August 10, 1993, and immediately after the stock is issued, the corporation’s gross assets cannot exceed $50 million. This test is based on the tax basis of the assets, which includes cash and the adjusted basis of other property. This is a one-time test for each stock issuance; if the company’s assets grow beyond $50 million later, stock that previously qualified does not lose its status.

The corporation must also meet an “active business” test. During substantially all of the shareholder’s holding period, at least 80% of the corporation’s assets, by value, must be used in the active conduct of a qualified trade or business. The law specifically excludes certain types of businesses from qualifying. Disqualified fields include:

• Services in health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting
• Any banking, insurance, financing, leasing, or investing businesses
• Farming, any business involving the extraction of natural resources, and the operation of a hotel, motel, or restaurant
• Any business where the principal asset is the reputation or skill of one or more of its employees

On the shareholder side, the requirements are also specific. The shareholder, who must be a non-corporate taxpayer such as an individual or a trust, must have acquired the stock at its original issuance. This means the stock was purchased directly from the corporation, received as compensation, or acquired through a gift or inheritance from an original holder. Purchasing the stock from another shareholder on a secondary market would disqualify it.

A key shareholder requirement is the holding period. To qualify for the gain exclusion, the taxpayer must hold the stock for more than five years. This five-year clock starts on the date the stock is acquired. For holders of stock options, this period begins on the date the option is exercised, not the date it was granted.

Calculating the Gain Exclusion

Once it is determined that both the stock and the shareholder meet the qualifications, the next step is to calculate the excludable capital gain. The excludable amount is governed by two factors: the date the stock was acquired and a cap based on either a fixed dollar amount or the stock’s basis. The percentage of the gain that can be excluded has changed over time, making the acquisition date important.

The tax law provides for three different exclusion percentages depending on when the QSBS was acquired. For stock acquired after September 27, 2010, a 100% exclusion of the eligible gain is permitted. For stock acquired between February 18, 2009, and September 27, 2010, the exclusion is 75%. Stock acquired after August 10, 1993, but before February 18, 2009, is eligible for a 50% exclusion. For stock qualifying for the 100% exclusion, the excluded gain is not subject to the Alternative Minimum Tax (AMT), but for the 50% and 75% exclusion tiers, a portion of the excluded gain may be subject to AMT.

The total gain eligible for this exclusion is not unlimited. The law imposes a cap on the amount of gain a taxpayer can exclude for any single issuing corporation. The maximum gain that can be excluded is the greater of two amounts: $10 million or 10 times the aggregate adjusted basis of the stock sold. This limitation is applied on a per-issuer, per-taxpayer basis.

To illustrate the $10 million cap, if an investor acquired QSBS for $500,000 and sold it for $12 million, the gain is $11.5 million. The investor can exclude $10 million of the gain, and the remaining $1.5 million would be taxed as a long-term capital gain. The $10 million limit is a cumulative lifetime cap for each corporation’s stock.

The “10 times basis” rule can be more advantageous for investors who made a larger initial investment. For example, if a taxpayer acquired QSBS for $2 million and sold it for $25 million, the gain is $23 million. Ten times the basis is $20 million (10 x $2 million). Since $20 million is greater than $10 million, the taxpayer can exclude $20 million of the gain, and the remaining $3 million would be subject to capital gains tax.

Rollover Provisions for Non-Qualifying Sales

Investors who sell small business stock but do not meet the five-year holding period may have an alternative. A different provision of the tax code, Section 1045, allows for the deferral of the tax owed. This is permitted provided the sale proceeds are reinvested into another Qualified Small Business Stock in a strategy known as a rollover.

The primary benefit of a Section 1045 rollover is tax deferral. By rolling the proceeds into new QSBS, the taxpayer does not have to recognize the capital gain in the year of the sale. The tax on that gain is postponed until the replacement stock is sold. A feature of this provision is that the holding period of the original stock is “tacked on” to the holding period of the new stock, allowing the investor to combine holding periods to meet the five-year requirement.

To be eligible for this rollover treatment, several conditions must be met. The stock that was sold must have been QSBS, and the taxpayer must have held it for more than six months. The taxpayer must use the proceeds to purchase new QSBS within a 60-day period beginning on the date of the sale.

The entire gain from the original sale can be deferred if the amount reinvested in the new QSBS is equal to or greater than the sale proceeds. If only a portion of the proceeds is reinvested, the gain must be recognized to the extent of the proceeds not reinvested. The taxpayer must make a formal election on their tax return for the year of the sale to defer the gain.

State Tax Treatment

While the federal tax benefits of selling QSBS are well-defined, the treatment at the state level is not uniform. State tax laws do not automatically follow federal rules, and the handling of the gain exclusion can vary significantly from one jurisdiction to another. This can impact the total tax liability from the sale.

States generally fall into one of several categories regarding their treatment of QSBS gains. A number of states fully conform to the federal exclusion. In these states, if a taxpayer qualifies for the 100% federal exclusion, they will also pay no state income tax on that gain. This provides the most favorable tax outcome.

Another group of states offers a partial benefit or has its own specific modifications. These states may conform to the federal law but impose additional requirements, such as requiring the business to have a significant portion of its operations or employees within that state. Others might offer a lower percentage exclusion than the federal government provides.

Finally, many states do not offer any exclusion for QSBS gains. In these non-conforming states, the entire capital gain is subject to state income tax, even if it is exempt from federal tax. Because state laws can change, verifying the current rules in the taxpayer’s state of residence at the time of sale is a necessary step.

Reporting the Sale on Your Tax Return

Properly reporting the sale of Qualified Small Business Stock on a federal tax return is the final step. After determining eligibility and calculating the excludable gain, the transaction must be accurately documented. The primary forms involved are Form 8949, Sales and Other Dispositions of Capital Assets, and Schedule D, Capital Gains and Losses.

The process begins on Form 8949. The taxpayer must report the full details of the stock sale, including the date acquired, date sold, total proceeds, and cost basis. The full amount of the gain is calculated and shown, which ensures the IRS has a complete record of the sale before any exclusion is applied.

To claim the QSBS exclusion, a specific entry is made on Form 8949. In column (f), the taxpayer enters the code “Q”. In column (g), the amount of the excluded gain is entered as a negative number (in parentheses). This entry directly reduces the total gain that will be carried over to Schedule D.

The net result from Form 8949, after subtracting the excluded gain, flows to Schedule D. Schedule D aggregates all capital gains and losses for the year to arrive at the final net capital gain or loss. This amount will be included in the taxpayer’s adjusted gross income. Following this procedure creates a clear record of the QSBS sale and exclusion.