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Maximizing the Gain Exclusion using QSBS

Keel Point

April 4, 2024

During the hectic moments leading up to the sale of a closely held company, taking the time to understand the tax implications of the sale is often the last thing on an owner’s mind.  Management meetings, due diligence requests, and negotiations are incessant while you are still trying to execute the demanding responsibilities of running a successful company.  In reality, a thoughtful and well-coordinated tax strategy for the sale of the business can dramatically increase the seller’s net proceeds.  The Qualified Small Business Stock (QSBS) or Section 1202 stock exclusion is a tax advantage that is hard to oversell.  Utilizing it in overarching strategic planning can be just as lifechanging as selling the business you’ve worked so hard to build.

What?

The QSBS or Section 1202 stock exclusion is specifically an exit event tax break, or tax advantage related to the sale of closely held stock.  This should not be confused with qualified business income (QBI) incentives.  For the sale of QSBS, the maximum a gain excludible for QSBS acquired after September 27, 2010 is:

  • The greater of $10,000,000 (reduced by certain previous eligible gains) or 10x the adjusted basis of your stock when issued

There are a few other caveats, but for our purposes determining the excludible gain should be the first step in planning.  One thing to note: if your initial investment of contributed capital or assets exceeds $1,000,000, the 10x formula is the most appropriate.  If you’ve bootstrapped the business, more thorough planning is required.  Excludible gains are considered per taxpayer per business, allowing multiple family members or serial entrepreneurs to participate in outsized savings.

Who?

The first qualification required of a potential QSBS participant is that the shares owned be in a US registered C-Corp.  If you are currently bootstrapping a business structured as an LLC or S-Corp, do not fret, all is not lost.  You can still participate after you convert to a C-Corp. and satisfy the required 5-year holding period.  You will also need to issue new qualifying stock shares from the new entity.  Another glaring qualification is that the asset must be stock.  Warrants, SARs, etc., do not count for QSBS purposes.  Lastly, the sale of the business must be a stock sale and not an asset sale.

Shareholders themselves are subject to several rules as well.  The asset must be bought with cash, property, or services (as long as the equity is 100% vested).  If you acquired QSBS with property, your basis for exclusion purposes is the Fair Market Value of the property on the date of contribution, essentially treating it as fully depreciated.  QSBS can be held by individuals, trusts, partnerships, LLCs, and S-Corps.

Finally, for a sale of QSBS to qualify for the gain exclusion, the total assets of the business cannot exceed $50,000,000.  Notice that the IRS looks at “Assets” and not “Value.”  Debt can become a problem if you own a capital-intensive business with a lot of leveraged assets.  Be sure to consult a tax professional as you begin exploring this planning strategy.

How?

As with any tax advantage, there are inherent planning opportunities. One is gifting shares to help expand the overall exclusion. Here’s an example:

Assume a business owner bootstrapped his firm and is about to sell it for $20,000,000.  He put about $10,000 of capital into the business, so his exclusion amount would be limited to $10,000,000 all in.  If he were to gift a portion of his equity, the recipient of the gifted stock would also enjoy a full $10,000,000 exclusion, bringing the total value of the exclusion for both sales up to $20,000,000.

Remember: the $10,000,000 exclusion is a lifetime amount, but if there are QSBS sales in subsequent years, you can always revert to the 10x formula

Another Planning example:

A business owner invests $10,000 of his own money into his business when he started 30 years ago.  Now he wants to sell and enjoy the fruits of his labor.  Let’s assume that he is confident that he will be able to sell the business for $22,000,000.  If that owner were to make an additional capital contribution of $3,000,000 in exchange for stock qualifying as additional QSBS, the result would be a $30.1mm exclusion as a result of the 10x formula (10 x $3,010,000 – all in basis).  After applying the exclusion, there would be no taxable gain in this transaction.

At the risk of overstating the obvious, 1202/QSBS stock planning is an outstanding opportunity for business owners to more fully participate in the value creation they’ve spent their lives pursuing.  I have been a part of transactions where a tax bill was the hangover to an otherwise wonderful transaction experience.  Consult your professional team about the relative merits of pursuing QSBS for your company and make sure to engage your financial advisor on how to integrate this strategy into your personal wealth creation.

Securities offered through Keel Point Capital, LLC, Member FINRA and SIPC. Investment Advisory services offered by Keel Point, LLC, an affiliate of Keel Point Capital, LLC.  Brokerage and Investment Advisory Services are offered under the Keel Point brand.  Keel Point does not provide tax, accounting, regulatory, or legal advice to its clients.  Keel Point’s opinions and investment vehicles may change at any time and without notice.  You should consult with your other advisors on the tax, accounting, and legal implications of these proposed strategies before any strategy is implemented.  This document is not a solicitation to invest in any investment product or offer any investment strategy.

 

 

 

Michael Stanley is a Wealth Advisor at Keel Point who specializes in Business Exit Planning and Business Advisory.  Leveraging years flying F-18 Super Hornets for the US Navy and helping business owners plan for and execute the sale of their businesses, he brings adaptability, energy, and a track record of mission success to the team.

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