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Qualified Small Business Stock: How Startup Investors can Minimize Capital Gains Taxes

Andrew Thompson • Sep 21, 2023

One Thing A Founder Should Consider Prior to Raising Seed Round Investments

QUALIFIED SMALL BUSINESS STOCK (QSBS): WHAT IS IT?


Shares of a qualified small business (QSB) defined by the Internal Revenue Code (IRC) are called qualified small business stock (QSBS). A QSB is a domestic C corp. issued stock and worth more than $50 million based on the original cost of is gross business assets. 26 USC §1202.


Tax benefits available to qualifying persons who meet specific requirements, provided they own qualified small business stock (QSBS) surround these provisions:


• Shares of a qualified small business (QSB), as defined by the Internal Revenue Code (IRC), are referred to as qualified small business stock (QSBS).


• QSBS qualifies for special capital gains treatment and reduced taxes when all requirements for qualification are met.


• The holding period for the stock determines how much they will receive as a tax benefit.


• By using the proceeds to purchase QSBS from another company, investors who sell their QSBS before the mandatory holding term expires can postpone capital gains.


QUALIFIABLE SMALL BUSINESS STOCK (QSBS): AN OVERVIEW


Individuals are permitted by the federal government to invest in small enterprises in accordance with Internal Revenue Code (IRC) Section 1202. As previously mentioned, a QSB is any current domestic C corporation whose assets, at the time of stock issuance or thereafter, do not exceed $50 million.


Only specific kinds of businesses can be classified as QSBs. Only businesses in the technology, retail, wholesale, and manufacturing qualify. Hospitality, personal services, finance, farming, and mining sector businesses are not eligible to be QSBs.


Federal taxes are not applied to capital gains from eligible small enterprises under IRC Section 1202. The following conditions must be met in order to claim the tax benefits of the qualifying stock:


1.      A corporation cannot be the investor.

2.      The shares had to be purchased by the investor at the time of issuance and not on the secondary market.

3.      The stock must have been held by the investor for a minimum of five years; • The investor must have paid for the shares with cash or other assets, or received it in exchange for a service. One or more of the issuing corporation's eligible crafts or enterprises must employ at least 80% of its assets.


QUALIFIABLE SMALL BUSINESS (QSB) STOCK TAX BENEFIT REQUIREMENTS


A QSB stock's tax status varies based on when it was purchased and how long it was kept. 1993 witnessed the enactment of Sec. 1202, the small company shares Capital Gains Exclusion, whereby a noncorporate shareholder avoids 50% of the gain from the sale of qualified small company (QSB) shares after five years of ownership.


The exclusion percentage rises to 75% for QSB stock purchased on or before September 27, 2010, but after February 17, 2009. The exclusion rate is 100% for qualified shares purchased before January 1, 2014, but after September 27, 2010.


Furthermore, pursuant to Section 1202, the annual gain allowance is constrained by a cumulative cap of $10 million and an annual ceiling equal to ten times the amount of QSB stock that is sold during the year. (This is applicable to each shareholder and each company.)


The policy goal of the exclusion was to encourage and reward taxpayers for making certain types of small-business investments.


There are holding requirements for the complete exclusion of net investment income (NII) tax and alternative minimum tax (AMT), which are supplemental tax benefits for investors in the QSBs.


The modified adjusted gross income (MAGI) amount over a predefined limit, adjusted from year to year, or the lesser of an individual's NII or NII tax, is subject to the NII tax. These are some examples of how exclusions work:


• A complete exclusion from capital gains for QSBS acquired after September 27, 2010. There is a 100% capital gain exception, which also covers exemptions from the NII and AMT taxes. A capital gains exclusion of 75% is available for QSBS purchased between February 18, 2009, and September 27, 2010. AMT applies to 7% of the excluded gain, though.


• For QSBS acquired between August 11, 1993, and February 17, 2009, there is a 50% capital gains exclusion.A MT applies to 7% of the excluded gain, as well.


Benefits to the Investor in Qualified Small Business Stock


Let us consider a taxpayer with $410,000 in ordinary taxable income who files as a single individual. Due to their income, they are subject to the highest capital gains tax bracket (20%). They achieved a profit of $50,000 from the sale of eligible small business stock that they had purchased on September 30, 2015. All of the taxpayer's capital gains are excludable, thus there is no federal tax owed on the gains.


Let's say the taxpayer bought the stock on February 10, 2009, and sells it for a $50,000 profit five years later. Capital gains would be subject to federal tax of 20% x (50% x 50,000) = $5,000.


Benefits also extend to shareholders who choose to sell qualified small business shares (QSBS) that they haven't kept for the required minimum five-year holding term. By reinvesting the profits from the sale of that qualifying small business stock (QSBS) into another QSBS within 60 days, they are able to defer the gain under Section 1045 of the IRC.


A qualified small business stock (QSBS) offering is a means of obtaining initial or additional funding for qualified startups and qualified established firms looking to expand.



These businesses can also pay employees in-kind, or with qualified small business stock (QSBS), which is a common way to pay employees for their services in situations where cash flow is scarce. Additionally, qualified small business stock (QSBS) could be utilized as a motivator for staff members to stay with the company and contribute to its expansion and success.


By Andrew Thompson 12 Apr, 2024
As a longtime consultant to entrepreneurs and startup founders at Landmark Advisors , not to mention a student of ancient scripture, one of the areas that fascinate and drives my efforts for funding and innovation most, is the prospect of improving human health. My interests lie both in the arena of increasing longevity as well as improvements to the quality of life of individuals as they occupy planet earth, and I see these two goals marching forward together rather than in conflict, at least most of the time. In this article, my focus lies more directly on longevity, as it provides a more objective target and there is more historical data from which we can discern what can be done to continue the progression. In the future though, I will dive into topics that address quality of life ("QofL") factors on their own terms, as I find this equally fascinating and of general concern to the human population at large. There are many ways to consider the possibility frontier, history and the hope for human longevity. Because our earliest recordings of human lifespan come from the ancient texts of the Hebrew scriptures, those texts are a great place to start. From Ancient Times to the Present This article is meant to encourage greater entrepreneurial thought around medical advancement and the capacity of for people to live their lives more abundantly, and not meant as an apologetic of Christian or Judaic faith, but as a good frame of reference for this discussion, it's helpful to consider that the patriarchs of the book of Genesis were said to have had very long lifespans compared with today, and then wihin several generations of the longest lifespans ever recorded few, if any people were living beyond the age of 100 years. Today, we see more people living beyond the age of 100 than at any time since teh earliest recorded human histories, but again, almost none are living beyond 120. Nonetheless, the prophets of the Old Testament found reason to believe that this would not always be the case, and the prophet Isaiah, in particular, didn't hesitate to proclaim what he foresaw for the future of human longevity. Interpreting Isaiah 65:20 In the Bible, Isaiah 65:20 mentions people living to be "100 years old," a verse often interpreted symbolically by Christian scholars as a sign of blessings and abundance, but not a literal increase in longevity. Hank Hanegraaff , a prominent Christian apologist, has discussed this verse in the context of biblical prophecy and its symbolic representation of a blessed and fulfilling life. It is difficult to find respected scholars who view this passage as meant to have a literal application, on the other hand, some who interpret it more figuratively seem to suggest that it foreshadows improving life expectancies and better health. In order to resolve an inherent contradiction in this passage, one must either conclude that there is an incremental progression of longevity as the cosmos approaches the new heavens and new earth (the "Whole of Scripture"), or that within the new heavens and new earth, there are people who still die, even if at a hundred years of age (the "Sudden Change"). In the context of Bible scholarship, the latter seems to make no sense. There is a near universal acceptance in the interpretation of the Bible that once the new heavens and earth are fully consummated, there shall or at least maybe a final judgment, but whatever death will occur at that time, the process of aging and death thereafter, will cease. "The last enemy to be defeated is death", etc. This is important because it creates a promise from the ancient scriptures that, understood from the Whole of Scripture, prophesies precisely what has been occurring in the last hundred years of human existence. Revisiting the Genesis Genealogies The genealogies in the book of Genesis, including Methuselah's 969 years, are subject to many different interpretations. Scholars like Dr. Elizabeth Johnson, who favors a symbolic approach to understanding the ages of Bibe patriarchs, suggest these ages may represent the importance of individuals rather than their literal lifespans, however, there is little evidence of how that importance would have been discerned over and against a description of the actual life span thought to be known for each of the patriarchs. Some scholars do debate, however, debate the reasons for a pattern of decreasing life expectancies in Old Testament times. Factors like environmental changes, dietary shifts, and genetic influences could have contributed to variations in lifespans over generations. The general theological supposition about this pattern is that sin had an impact over time that eventually settled in and hit a natural bottoming out, according to God's providence. Historical Stagnation in Life Expectancy Throughout history, factors like infectious diseases, limited medical knowledge, poor nutrition, and high infant mortality rates contributed to stagnant life expectancy, highlighting the challenges of the past. Infectious Diseases: Infectious diseases have historically been a significant contributor to mortality and reduced life expectancy. Documentation from sources like historical medical records, epidemiological studies, and anthropological research showcases the impact of diseases like tuberculosis, smallpox, cholera, and influenza on population health and life expectancy. Research studies provide insights into how diseases shaped human populations and life expectancy over time. Limited Medical Knowledge: Limited medical knowledge in earlier centuries meant that many illnesses and conditions were poorly understood and often untreated. This lack of medical understanding led to higher mortality rates and shorter life expectancies. Historical documents, medical journals, and scholarly articles on the history of medicine offer documentation of the evolution of medical knowledge and its impact on improving life expectancy. Poor Nutrition: Poor nutrition, including inadequate access to nutritious food, deficiencies in essential nutrients, and periods of famine or food scarcity, has been a significant factor in reduced life expectancy. Published studies highlight the link between nutrition and health outcomes throughout history. High Infant Mortality Rates: High infant mortality rates, often due to factors like infections, lack of prenatal care, and poor sanitation, have historically contributed to lower life expectancies. Historical demographic data, mortality records, and studies on child health and survival rates provide evidence of the impact of infant mortality on overall life expectancy averages. By examining historical data, medical literature, and demographic studies, we can gain a comprehensive understanding of how factors such as infectious diseases, limited medical knowledge, poor nutrition, and high infant mortality rates have historically influenced life expectancy trends. Revolutionizing Life Expectancy in the 20th Century Advancements in medical technology, sanitation, clean water access, the use of antibiotics and improved nutrition led to a dramatic rise in life expectancies globally during the 20th century. For most of human history, it’s been estimated that global life expectancy at birth has bounced between 20 and 30 years. Beginning approximately in the year 1820, global life expectancy started its exponential ascent, seeing its most impressive gains after 1950 as modern sanitation and medical advancements began to trickle down to developing nations. Navigating 21st Century Challenges Despite progress, the 21st century faces obstacles such as antimicrobial resistance, rising chronic diseases, healthcare disparities, environmental issues, and global pandemics, impacting life expectancy improvements. During the pandemic, the US saw declining life expectancies for consecutive years, 2020 and 2021, while making a comeback in 2022. It's too early to conclude that this, while directly, is simply a result of the pandemic, or if a reduction was more predictable regardless of the pandemic itself. The two biggest issues connected with longer term trends toward a decrease in life expectancy, however, appear to be mental health and chronic disease, especially diabetes, heart disease and cancer. If you consider mental health to be one of many forms of chronic disease, then every factor contributing to decreasing life expectancies is related to chronic disease. By focusing efforts at improvements in treatment, and most importantly, prevention of these conditions, there is a high probability we can eliminate the negative pressure on life expectancies and return to a long term trajectory of increased life expectancy. Promising Developments for Increased Longevity Exciting advancements in medical technologies, genetics, nutrition research, and healthcare infrastructure, especially in developing nations, provide optimism for extending human life expectancies. We will be developing a series of articles addressing significant innovations that continue to impact both longevity and quality of life as we continue adding content on this subject. There are other remarkable achievements in healthcare: breakthroughs in cancer treatments, cardiovascular disease management, and medical device technology that far exceeds earlier capabilities in all of these areas. All of these advancements in care and prevention have contributed significantly to longer and healthier lives, particularly in regions like Asia and even on the continent of Africa. Anticipating the Future The next 25 year period holds great promise with ongoing medical research, preventive healthcare emphasis, global healthcare accessibility improvements, and efforts to address environmental and social health determinants, potentially extending human life expectancies further. We predict that by 2050, the US will have a life expectancy at birth of between 80-85 years, and that longevity increases in other parts of the world will be even greater than they will be here, more than 10%, for example, in Africa, Latin America and parts of Asia. Conclusion: A Bright Outlook The journey of human longevity reflects a blend of interpretations, scientific advancements, and societal progress. While challenges persist, the trajectory toward longer, healthier lives offers hope for a brighter future, both literally and symbolically. For more information or to discuss scaling an innovative health technology, please contact Landmark Advisors to get started.
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