Qualified Small Business Stock (QSBS) Tax Planning
Jackson Walker advises founders, investors, private equity firms, and growing businesses on the significant tax benefits available for “qualified small business stock” (commonly referred to as “QSBS” or “1202 stock”) under Sections 1202 and 1045 of the Internal Revenue Code of 1986, as amended (the “Code”). Our attorneys help clients navigate the complex qualification requirements, structuring considerations, and planning opportunities associated with QSBS, working to maximize tax-advantaged outcomes at every stage of a company’s lifecycle.
QSBS Tax Benefits under Section 1202 of the Code
Under Section 1202 of the Code, a percentage of the gain from a sale of QSBS that has been held for specified minimum holding periods can be excluded from gross income of certain taxpayers. The applicable gain exclusion percentage can be as high as 100% and depends on when the stock was acquired (or, in certain cases involving specified transfers, treated as acquired) and how long it has been held.
For a given tax year, the QSBS exclusion is generally capped at the greater of (1) a specified dollar amount ($10 million or $15 million, depending on when the stock was acquired), which is reduced by the amount of the taxpayer’s prior excluded QSBS gains with respect to such corporation, and (2) ten times the shareholder’s aggregate adjusted basis in the QSBS sold in such year.
The current corporate tax rate has made C corporations increasingly attractive as a choice of entity, and the additional benefits of QSBS status are an essential component of entity-selection planning.
QSBS Rollovers under Section 1045 of the Code
Section 1045 complements Section 1202 by allowing taxpayers who have held QSBS for more than six months (and who may not have achieved the specified minimum holding period for the Section 1202 exclusion) to defer gain on the sale of their QSBS by rolling the sale proceeds into replacement QSBS within 60 days. Taxpayers that properly complete such “QSBS rollovers” can also include the holding period for the original QSBS for purposes of determining whether the replacement QSBS satisfies the minimum holding period requirement of Section 1202. The rules for QSBS rollovers present significant tax planning opportunities.
Our QSBS Services
Jackson Walker’s tax attorneys counsel clients across the full spectrum of QSBS planning, including:
Entity Formation and Choice of Entity. QSBS tax benefits can factor significantly in choice of entity considerations and other structuring issues for new businesses. We advise on the threshold decision of whether to organize a business as a C corporation and structure the initial capitalization to satisfy QSBS eligibility. This includes ensuring that the issuing corporation’s aggregate gross assets do not exceed the applicable threshold for aggregate gross assets, that stock is issued for qualifying consideration at original issue, and that the corporation meets the active business requirements from the outset.
Ongoing Compliance and Monitoring. Maintaining QSBS status requires continuous vigilance. We help clients monitor and document ongoing compliance with QSBS requirements (e.g., the active business requirement, limitations on holdings of non-business assets, prohibited stock purchases, etc.). We also advise on the impact of subsidiary operations, joint ventures, and disregarded entities on qualification.
Maximizing the QSBS Gain Exclusion. The rules of Section 1202 provide opportunities for well advised taxpayers to significantly increase their available QSBS tax benefits. We advise clients on tax planning techniques to maximize the available gain exclusion under the QSBS rules. These techniques include lifetime gifting of QSBS to family members or trusts to create separate per-donee exclusion amounts, as well as the incorporation of appreciated partnership or LLC assets to take advantage of more favorable gain exclusion limitations.
Section 1045 Rollover Planning. QSBS rollovers under Section 1045 of the Code can provide a valuable tool for preserving and increasing QSBS tax benefits, even when the minimum required holding period may not have been satisfied. We advise clients not only on the technical requirements for QSBS rollovers, but also on tax planning techniques to maximize the QSBS tax benefits achieved with respect to replacement QSBS.
Partnerships, Funds, and Co-Investments. Partnerships and other flow-through structures introduce important and complex issues under the QSBS rules. We advise venture capital funds, private equity sponsors, and co-investors on the treatment of QSBS held through partnerships and LLCs, including the allocation of QSBS gain among partners and the interplay between partnership-level and partner-level QSBS rollover elections.
M&A Transaction Structuring. M&A transactions involving QSBS can involve complex structuring considerations. We advise our buyer clients on how to structure acquisitions in a manner that leverages the QSBS rules and our seller clients on how to maximize their QSBS benefits. Rollover equity issued in an M&A transaction often raises particularly challenging issues. We advise our clients on rollover structures that preserve QSBS tax benefits in their continuing equity interest in the business.
Documentation and Audit Preparedness. In the event of an audit of a QSBS reporting position, numerous shareholder and corporate level considerations may be challenged by the IRS. We assist clients in building and maintaining the contemporaneous documentation necessary to support a claim for QSBS eligibility. Because QSBS eligibility may be challenged by the IRS years after the fact, thoughtful documentation at the time of issuance and throughout the holding period is essential.
Tax Insurance. In certain circumstances, taxpayers may wish to obtain a tax insurance policy with respect to their QSBS tax reporting position. Such policies may require written support for the reporting position from qualified tax advisors. We advise clients on the benefits of such tax insurance policies and help them qualify by providing the written support needed for the insurance underwriters.
Why Jackson Walker
The intersection of tax planning, entity selection, and M&A structuring demands counsel who understand both the opportunities and constraints presented by the QSBS rules and the practical realities of building and exiting a business. Jackson Walker’s Tax Section brings that combination of depth and experience to every QSBS engagement, helping clients capture the full value of one of the most powerful tax incentives available to entrepreneurs and investors today.
