What does this mean practically speaking? Founders, along with others with original issue stock, can get a possible 0% effective tax rate on gains from the sale of all or part of their business, as long as the acquisition and sale of the business was, and is structured properly. Do not feel too let down, however, if your stock does not fall into the 100% exclusion period, you may still be eligible for a 50%, 60%, or 75% exclusion under §1202.
Qualified Small Business
Qualified Small Businesses are generally the only entities who can issue QSBS. A Qualified Small Business is (1) a domestic C corporation (but not a Disc, RIC, REIC, REMIC, Cooperative, or various other corporations); (2) whose aggregate gross assets before issuance, and up until immediately after issuance, do not exceed $50,000,000; (3) which agrees to submit any reports as required by the IRS (no reports are currently required); and (4) which is engaged in an active business during substantially all of a taxpayer’s holding period of the QSBS.
The active business requirement is met if 80% or more of the corporation’s assets are used by the corporation in actively conducting certain qualified trade or business. A business or trade is generally qualified for the purposes of §1202 if it does not involve: (1) the provision of one of several services (i.e. law, accounting, or engineering), or (2) doing business in any one of several industries (i.e. farming, banking, and oil and gas).
Qualified Small Business Stock
Stock is considered QSBS if it is original issue stock (not previously owned) in a qualified trade or business, received in exchange for money or property (other than stock), or as compensation for services to the corporation (other than services as an underwriter of the stock).
Finally, for the exclusion to qualify as to your gain the stock being sold must have been held for more than five years.
California has its own similar 50% exclusion at the state level, set out in Revenue & Taxation Code §18152.5. The main difference is the requirement that the corporation have at least 80% of its payroll be attributable to employment in California at the time the stock is issued. Unfortunately §18152.5 does not apply to sales made after January 1, 2013. However, if you sold your stock before 2013 but are still taking installment payments for that sale, you may be eligible for the 50% exclusion.
For advice on whether your business may be a Qualified Small Business, or if you have Qualified Small Business Stock, it is recommended that you contact a professional who is qualified to render such counsel.