By: Ted Sutton, Esq.
Introduction
From a very young age, Elong Muskrat was always passionate about providing solutions to the world’s most difficult problems. Over the years, Elong had founded multiple companies in different industries. Many of them failed. However, some of them were wildly successful.
One day, Elong wanted to provide a solution to help reduce the world’s fossil fuel usage. Since cars contribute heavily to this use, Elong decided to start an electric car company. These electric cars would have all the same features without having to make the trip to the gas station.
After reducing his idea into a business plan, Elong formed Edison Electric Vehicles in 2011, a Delaware C-Corp, where he initially owned 100% of the stock.
In the following decade, Edison manufactured over 1 million electric vehicles. Because car manufacturing is an expensive endeavor, Edison’s gross assets were only worth $40 million.
In 2021, Elong was drawn to another serious issue. He noticed the ubiquity of social media and all of its negative impacts. Titter, a platform where users would constantly exchange a tit for tat, was the primary culprit. Elong wanted to purchase Titter and change its algorithms for the betterment of society. However, he would need to finance the purchase of Titter by selling his stock in Edison.
In 2022, Elong sold his stock in Edison to Riviera Motors, another electric vehicle maker, for $9 million. He then used that sum to finance his purchase of Titter.
Being an extremely smart person, Elong was curious as to the tax consequences of his stock sale. His tax advisor told him that he may qualify for the Qualified Small Business Stock (QSBS) exemption. If he does, he could save millions of dollars in taxes.
Qualified Small Business Stock
So what exactly is QSBS? Under Section 1202 of the Internal Revenue Code, a taxpayer may be exempt from paying capital gains tax when selling QSBS stock if they meet certain requirements. Each of these are listed below.
- QSBS Only Applies to C-Corp Stock
First, the stock must be held in a C-Corp. S-Corp stock, LLC units, and partnership interests are not eligible for the QSBS exemption.
Edison was formed as a C-Corp. The first requirement is easily met.
- The C-Corp Shares Must be Acquired in the Original Issuance
Second, the C-Corp shares must be acquired in the original issuance.
Because Elong owned 100% of Edison’s stock when he formed it, the second requirement is met.
- The C-Corp Must be a Qualified Small Business
Third, the C-Corp must be a qualified small business. A qualified small business is a domestic C-Corp which holds gross assets that have never exceeded $50,000,000.
Here, Edison’s gross assets were only ever worth $40 million. Because of this, Edison meets the definition of a qualified small business.
- 80% of the Firm’s Assets must be Used in Active Conduct
Fourth, a minimum of 80% of the firm’s assets must be used in active conduct, or in an ongoing business. If stock is acquired in a passive C-Corp, it cannot qualify for the QSBS exemption.
Because Edison manufactures cars, it easily meets the requirement of active conduct.
- The Stock Cannot be in Certain Lines of Business
Fifth, the stock of certain lines of business will not qualify for the QSBS exemption. Some of these include banking, insurance, farming, leisure and hospitality, and other professional businesses.
Because Edison manufactures cars, it does not fall into any of the aforementioned categories. It still qualifies for the QSBS exemption.
This is all great news for Elong. His stock qualifies for the QSBS exemption because it has met the aforementioned requirements. He can save money by not having to pay the capital gains tax associated with the sale of stock. However, how much Elong saves depends on when the stock was held and how much the stock sold for.
- When the Stock was Held
If the taxpayer acquires QSBS stock after September 27, 2010, and holds it for more than 5 years, the taxpayer can exclude 100% of the capital gain upon its sale.
If the taxpayer acquires QSBS stock between February 18, 2009 and September 27, 2010, and holds it for more than 5 years, the taxpayer can exclude 75% of the capital gain upon its sale.
If the taxpayer acquires QSBS stock between August 11, 1993 and February 18, 2009, and holds it for more than 5 years, the taxpayer can exclude 50% of the capital gain upon its sale.
Elong formed Edison in 2011 and sold his Edison stock in 2022. Because of this, Elong may exclude 100% of the gain.
- Maximum Excludable Gain Recognized
The IRS sets limits on how much a taxpayer can exclude upon the sale of QSBS stock. The maximum eligible gain that a taxpayer can recognize is capped at the greater of $10 million, or 10 times the aggregate adjusted basis in the stock.
Here, because Elong sold his Edison stock for $9 million, he is able to exclude the entire gain associated with its sale.
Conclusion
If they meet the requirements, qualifying for QSBS can be advantageous to taxpayers who acquire and sell stock in smaller C-Corps.