How Buying Qualified Small Business Stocks Help Investors with Tax-Saving
It’s commonly known that investing in small businesses is riskier than larger, more well-established ones. In addition, people may feel discouraged by the tax costs incurred that reduce investor’s profits when their realized value increases. To incentivize people to invest in these lower cap ventures, the federal government initiated tax benefits for those investments that are deemed to be qualified small business stock (QSBS), which are defined as shares of a qualified small business (QSB), according to the Internal Revenue Code. To qualify for such tax benefits, the company must be a QSB, and the investor and holding must also comply with specific guidelines.
How does a company become a QSB?
For a company to be considered a QSB, it must fall under certain categories. For example, it must be a domestic C corporation (as opposed to S corporation) with less than $50 million in aggregate gross assets on or after the issuance of stock that an investor purchase. In addition, they cannot be in the sectors of personal services, finance, agriculture, or hospitality. They must be within technology, retail trade, wholesale, transportation, or the manufacturing sectors. Finally, during the taxpayer's holding period, the issuing corporation must use at least 80% of its assets in the operations of one or more qualified trades or businesses.
Requirements for QSB owners
To claim the tax benefit, the owner and holding must fulfill certain requirements as well. To begin, the owner must be an individual investor – i.e. not a corporations, who have held the stock for at least five years. Moreover, the individual cannot have purchased it from the secondary market but rather the original issue, through cash, property, or received it as a return payment.
What are the tax benefits?
Depending on when the stock was acquired and how long it has been held, the tax is treated differently. All investors can exclude 100% of capital gains on QSBS within the cap of $10 million, or 10 times the adjusted basis of the stock—whichever is greater. Gains greater than $10 million or 10 times the adjusted basis of the stock can have a 28% capital gains tax after the 10x threshold.
To fully understand these tax benefits, it is also important to look at alternative minimum tax (AMT) and net investment income tax (NII). When tax exemptions allow someone to pay disproportionately low taxes compared to their income level, AMT is applied. For the amount of modified adjusted gross income, the NII tax is applied (with the following exclusions, according to Investopedia):
100% capital gains exclusion for QSBS acquired since Sep 27, 2010: 100% of which can be applied to capital gains exclusion (including AMT, NII tax)
75% capital gains exclusion for QSBS acquired between Feb 18, 2009, and Sep 27, 2010: 7% of which is subject to AMT.
50% capital gains exclusion for QSBS acquired between Aug 11, 1993, and Feb 17, 2009: 7% of which is also subject to AMT.
Through qualified small business stock, businesses and investors can save large amounts of money on their taxes. In order to do so, the company must qualify as a QSB and the owner must be an individual, and then the investor can enjoy these tax exemptions. Here at Bridge Point Capital, we often invest in companies that qualify for this tax benefit and then help them grow post-investment. Through connecting backers with these companies, Bridge Point Capital uses qualified small business stock to help investors and businesses alike. Naturally, any tax concepts should be reviewed and analyzed by your CPA to ensure that these concepts apply.