Tax free income is hard to beat, right? Tax exclusions are one of the best outcomes you can create.

The most common example is an exclusion on your residence - 500k after 2 years!

Qualified Small Business Stock provides a less known, much bigger opportunity.

/THREAD

Qualified Small Business Stock (QSBS, QSBC, Section 1202 Stock) allows holders of original issuance stock to sell their shares and pay zero tax on the first $10 million+ of capital gains.

Let's dig into what qualifies, and the benefits and drawbacks of choosing to be a QSBC.

Eligibility - There are several requirements you have to meet in order to be eligible.

1. The stock must be issued to a non-corp stockholder (individual or pass-through entity)
2. The entity must be a C-Corp at the time of stock issuance

3. The stock must be part of the original issuance (not secondary market)
4. The owner must hold the stock for 5+ years
5. At least 80% of the entities assets must be used in the operations of its qualified trade or business (not an investment company)

6. Ultimately the business needs to be a certain type of small business. This is a bit of a gray area, but 1202 requires the C-Corp be in "qualified small business activities." This is defined by exclusion, but mostly covers service businesses (similar to SSTB covered under QBI)

The tax treatment of QSBS depends on when the stock was acquired, but the PATH act of 2015 allows owners to exclude 100% of capital gains on all QSBS up to the GREATER of
- $10 MM
- 10X the adjusted basis of the stock

There is no AMT tax either - This is actually tax free.

The Rollover -

Beyond the 5 year exclusion, there is another great deal.

After you have held QSBS for more than 6 months, you can roll your capital gains into another QSBC tax free.

You can add your original holding period to the new shares to get to 5 year exclusion.

The Benefits -

1. Tax free! You can sell your company and get potentially over 10MM of capital gain excluded. What a deal.

2. Is tax free sale not enough?

3. Sometimes double tax doesn't have to be that bad - see more in drawbacks below.

The Drawbacks -

1. Double Tax - Definitely the largest drawback in the whole picture, although muted with TCJA. The corporation will pay 21% on all taxable income, and the owner will pay another tax on any dividends distributed. This will result in a higher net tax on profits.

2. Compliance - It is worth getting this right. Setup, elections, etc. A premium is being paid for the classification and ability to exclude. Don't mess it up!

3. Blowup risk - The tax premium paid worsens pain of not having the desired exit. This includes timing risk on sale.

4. Other sale issues - The buyer may not want to purchase stock. Buyers want to buy assets rather than stock to amortize goodwill and avoid double tax. This could affect valuation.

Would love feedback from folks in the trenches as to how this plays out deal after deal.

Who should do this -

Qualified companies that will not be profitable and will sell for high valuations. This is the no brainer, and why many startups elect to go this route.

The big downside is double tax. It's a no brainer if you are going to pay no tax for the ride.

Who shouldn't do this -

1. People that don't have timeline control - have to hold 5 years.
2. Profitable businesses that will distribute all of their profits.
3. Businesses that may not sell.
4. Disorganized people.
5. People who are unsure if they should do this.

So what should you do? This is my favorite part:

It depends.

1202 is a really great trick with a potentially magical outcome, but the specifics need to be modeled out.

Find a great team of pros that know exactly what they are doing and follow their advice.

Good luck!

If you like this thread, find more like it at the the thread of threads below:

https://twitter.com/baldridgecpa/status/1333953486208241665?s=20

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