Harry Potter and the Chamber of Secret QSBS Exclusions | Greenberg Glusker LLP

Are your shareholders leaving money on the table? Some tax planning strategies, much like the magic spells in the Wizarding World of Harry Potter, require predetermined spells to bring them to fruition. Eliminating profits from the sale of Qualified Small Business Shares (“QSBS”) under section 1202 is one of those magic spells that can negate millions of tax liabilities. The rules contained in Section 1202 of the Internal Revenue Code allow a taxpayer to potentially exclude up to $500,000,000 of taxable income from the sale of QSBS (with proper planning).

To determine whether shares issued by a corporation qualify for QSBS treatment, the taxpayer should ask themselves the following questions:

• Is the company taxed as a C corporation?
• Is the company actively engaged in trade or business?
• Does the Company have gross assets of less than $50,000,000 (including goodwill if the LLC is converted to a C corporation) at the time such shares are issued?
• Is the Company engaged in a trade or business other than trade or the provision of personal services, such as an accountant, lawyer, doctor, consultant, or athlete?
• Is the Company engaged in a trade or business other than operating a hotel, motel, restaurant or similar business?
• Is the Company engaged in a trade or business other than investing, leasing, financing, banking or any other similar business?
• Less than 10% of the company’s assets are compromised by real estate or shares of an unrelated company?

If the answer to each of the above questions is “yes” and such QSBS has been owned for more than 5 years at the time of the divestiture, the shareholders of such a company may be entitled to exclude the greater of $10,000,000 or 10 times the basis of their stock (provided that all other requirements are also met). There are certain exclusion restrictions for QSBS released prior to 2010. [1]

To illustrate the benefits of QSBS over the life cycle of a company, we have included the following example illustrating the tax savings for a new $100k/year company that sells for $2 million at the end of year 5:

The above example shows that one level of tax is not always better than two.

It should be noted that there are certain actions that a company can take that could render its shares eligible to use QSBS. Taxpayers should avoid the following while maintaining QSBS status:

• Purchase of shares from another shareholder instead of the Company,
• QSBS contribution to the partnership,
• Redemption by the Company two years before or two years after the issue of QSBS,
• Provision of services related to prohibited services, such as medical research or a Fintech application, without obtaining the opinion of a tax consultant,
• Failure to hold shares for 5 years prior to sale,
• Unable to renew under Section 1045 if QSBS is sold before the expiration of the 5 year term,
• Not knowing if SAFE Companies are treated as capital or prepaid contract for tax purposes, and
• Waiting too long to transition from LLC to C-corporation when scheduling the maximum QSBS exclusion and accidentally exceeding the 50m gross assets test.[4]

If a shareholder is eligible for the QSBS exemption, no documentation is required to accompany the shareholder’s tax return in order to claim the exemption. Rather, taxpayers should simply know to exclude the appropriate amount of income from the sale of their QSBS. It is also critical that taxpayers keep sufficient records to support their position in the event of an audit.

While this article covers the basics, there are additional nuances when applying for a QSBS exemption.