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Understanding the QSBS Tax Exemption

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Paul S. Lee, Chief Tax Strategist for Northern Trust

Business owners who are able to access the QSBS tax exemption may find added financial relief from the impact of COVID-19 by reducing future capital gains taxes for themselves and their investors.

In the wake of COVID-19, many small business owners are looking for ways to attract capital from investors to fund ongoing operations and keep their businesses afloat. These business owners, along with their investors, may find an additional financial lifeline in the form of a little-used provision of the U.S. tax code.

Internal Revenue Code Section 1202 establishes guidelines for the use of the Qualified Small Business Stock (QSBS) tax exemption. The tax rule, under certain circumstances, allows individuals who invest in qualifying small businesses and receive favorable capital gains treatment when they ultimately sell their interest in the business later on (based on certain specified time periods for holding the investment). Proper use of the exemption may lead to substantial tax savings for investors in these businesses when it comes time to realize capital gains from the sale of their investment.

What is a Qualified Small Business (QSB)?

Not all small businesses qualify for the tax exemption. It is limited to U.S. firms operating as C corporations, with assets that had an original cost value of $50 million or less at or immediately following the issuance of the stock. QSB eligibility is restricted to active trades or businesses, including those in the wholesale, manufacturing and retail sectors, and certain technology companies.

The exemption has mainly been used by early-stage entrepreneurs. Traditionally it has been under-utilized outside of the technology industry. However, legislative changes over the more than 25 years since section 1202 was written have now made the QSBS exemption more accessible.

Three Primary Benefits QSBS Offers Qualifying Business Owners and Investors of Closely Held Businesses

  • Exclusion of up to 100 percent of capital gain taxes realized on the sale of a small business
  • Option to roll over and defer taxable gains by reinvesting in other QSB companies
  • Ability to “multiply” the exclusion through gifts, transfers at death, and careful pre-issuance planning

Why We May Be Reaching a Tipping Point on QSBS

As a result of the toll that COVID-19 has taken on the U.S. economy and the growing size of economic relief programs, such as the Coronavirus Aid, Relief, and Economic Security (CARES) Act, the federal government is expected to raise income taxes at some point in the near future to help offset its ballooning budget deficit. During the last recession, the federal government made significant enhancements to the QSBS tax exemption to spur small business growth, and it may do so again.

For business owners, their families and potential investors in small businesses, any increase in federal income tax rates would make access to a QSBS tax exemption even more valuable, both as a way to attract new capital and also as an important wealth planning tool. Developing a better understanding of how to qualify for a QSBS tax exemption may help many small business owners affected by COVID-19 raise additional money from investors in order to fund ongoing operations and get their businesses back on track.

To learn more about how to access the advantages of the QSBS tax exemption, download the full report. If you are ready to discuss how you might incorporate the QSBS tax exemption into your own business or overall wealth plan, please contact a Northern Trust advisor.

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Disclosures

This information is not intended to be and should not be treated as legal, investment, accounting or tax advice and is for informational purposes only. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. All information discussed herein is current only as of the date appearing in this material and is subject to change at any time without notice.

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