The Qualified Small Business Stock (QSBS) status under Section 1202 of the Internal Revenue Code provides a significant tax advantage for small business owners (i.e., Founders) and investors. It allows for a 100% capital gain exclusion on the sale of small business stock, up to certain limits. However, maintaining this status requires strict adherence to several conditions. Failure to meet these conditions can result in the loss of QSBS status and valuable tax benefits.
Here’s how you can lose your QSBS status:
Exceeding the Asset Threshold
One of the primary requirements for QSBS status is that the company’s gross assets must not exceed $50 million at any time from August 10, 1993, to immediately after the issuance of the stock. If the company's assets exceed this limit, the stock issued after this point will not qualify as QSBS.
Changing the Nature of the Business
QSBS status is only available to C corporations that are engaged in a qualified trade or business. If the corporation changes its business to a non-qualified trade or business and continues in this manner for a significant part of its activities, it may lose its QSBS status. Non-qualified trades or businesses include certain service-based businesses like health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, and any business where the principal asset is the reputation or skill of one or more of its employees.
Not Meeting the Active Business Requirement
At least 80% of the corporation’s assets must be used in the active conduct of a qualified trade or business during substantially all of the shareholder’s holding period. If the corporation fails to meet this requirement, the QSBS status may be lost.
Exceeding the Holding Period
To qualify for the QSBS exclusion, the shareholder must hold the stock for more than five years. If the stock is sold before this period, QSBS capital gain exclusion will not apply.
Redemptions
Certain redemptions can disqualify stock from QSBS status. If the corporation redeems stock from the shareholder or a related person within two years before or after the stock issuance, the stock may not qualify as QSBS. Similarly, if the corporation redeems a significant amount of its stock within a two-year period beginning one year before the stock issuance, the stock may not qualify as QSBS.
In conclusion, while the QSBS status under Section 1202 provides a significant tax advantage, maintaining this status requires careful adherence to the rules. It’s crucial for small business owners and investors to understand these rules to avoid losing their QSBS status. Consulting proactively with your legal advisors/tax professionals is highly recommended to ensure compliance with these requirements.
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