How to Avoid Millions of Dollars in Capital Gains Tax by Using the Qualified Small Business Stock Exclusion

How To Avoid Millions of Dollars In Capital Gains Tax By Using The Qualified Small Business Stock Exclusion

Most entrepreneurs don’t know of a simple way to avoid millions of dollars in capital gains tax. Section 1202 of the Internal Revenue Code grants non-corporate taxpayers a tax break of up to $10,000,000 in capital gains on “qualified small business stock” that the taxpayer holds for more than five years. This is a huge exclusion.  I believe all entrepreneurs should have a basic grasp on Section 1202’s high-level requirements so that they can take full advantage of its tax breaks. So, here they are.

What Are The Requirements for Capital Gains Tax deductions? 

C-Corporation for Capital Gains Tax Deductions

In order to qualify for, capital gains tax deductions, the issuer of the stock must be a C-corporation. S-Corporations or LLCs taxed as partnerships do not qualify. Founders should consider this in particular when choosing an entity.

Less Than $50,000,000 in assets 

The issuer must have less than $50,000,000 in aggregate gross assets before and immediately after you receive your shares.

80% of Assets Used

The issuer must use at least 80% of its assets in the active conduct of its Qualified Trade or Business (more on that below).

Issued After August 10, 1993

The company must have issued the stock after August 10, 1993.

Original Issuance

Generally for, capital gains tax deductions, you must acquire the stock directly from the company.  This becomes more complicated if you receive equity compensation, like options or restricted stock, or if you hold convertible debt or a warrant.

Domestic Corporation

The company must be organized in the United States.

I have nothing insightful to add about this windmill, which probably means I’m past my prime and definitely means it’s almost the end of the year.

Qualified Trade or Business 

The issuer’s business not be any of the following.  I generalized the descriptions below for simplicity’s sake.  For details, see the statute.

  • Professional services
  • Financial services
  • Farming
  • Mining
  • Hospitality

Five Year Holding Period

You must hold the stock for more than five years before you sell it for capital gains tax deductions.  This also begins becomes more complicated if you receive equity compensation, like options or restricted stock, or if you hold convertible debt or a warrant. This will also become more complicated if a company began as an LLC, and converted into a C-corporation.

In Exchange for Money or Other Services

The company must issue the stock in exchange for money or other services.  If the company issues the stock in exchange for other stock, it won’t count.

Conclusion: 

We have written about Section 1202 before herehere, and here. This post is just a summary, and Section 1202 can get complex quickly depending on the situation.  If you have any questions about 1202 or any of its complexities, feel free to contact me.

Carney Badley Spellman is about Advocacy, Strategy, Results. Located in Seattle, we are a full-service law firm committed to exceptional client service and professional excellence. Our firm serves individuals and businesses of all types and sizes. Also, our attorneys work with closely-held companies to Fortune 500 corporations in the Pacific Northwest and across the United States. Although Carney Badley Spellman‘s location is in Seattle, Washington, we are proud to be a part of the Washington state community and communities across the nation.

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Ashley K. Long