Posted on: November 1st, 2022
There’s a type of stock that could potentially enable you to raise capital for your growing business, attract top employees and save millions of dollars in taxes down the road.
These shares are known as qualified small business stock (QSBS), and they’ve become a powerful financial tool for some entrepreneurs and investors in recent years. But they’ve also become part of the debate about whether the affluent get excessive tax breaks—and, as a result, some lawmakers would like to see changes to the QSBS rules.
As a business owner, specifically, you may find a lot to like about QSBS. With that in mind, here’s a closer look at how QSBS works, ways to use it in your company and as an investor, and how it could potentially play a role in wealth planning strategies for your family.
The purpose of QSBS is to motivate early investment in promising small businesses that need capital to expand their operations. The incentive is, to put it mildly, eye catching: Early investors can avoid paying any capital gains tax on as much as $10 million in profits they generate from selling their shares, if certain conditions are met.
What’s more, QSBS investors may have the ability to pass on that sizable tax break to their heirs and other family members (more on that later).
These features can make QSBS of particular interest to entrepreneurs—especially those who are looking to raise money for their business, motivate and retain key talent that’s vital to the company’s success, invest in their peers’ startups, and enjoy significant tax savings.
The details of the potential tax break vary depending on factors such as when the QSBS was acquired and how long it was held.
In all cases, however, the amount of the gain that avoids taxation is $10 million or 10 times the original investment’s adjusted cost basis (whichever of the two is greater).
Example: Say your income puts you in the highest tax bracket for capital gains tax (currently 20 percent). If necessary conditions are met and you sell your QSBS six years after you invested and realize a capital gain of $500,000, you’ll pay $0 in federal tax—saving you at least $100,000.
Businesses that qualify to issue QSBS (see below) should consider using these shares strategically if doing so could help further their goals. Two ways some small businesses harness the power of QSBS are:
There are many technicalities associated with QSBS, not surprisingly, and it’s always best to consult with trusted experts on the topic.
For example, if your business wants to issue QSBS, it has to meet requirements including (but not limited to) the following:
Any individual can potentially invest in QSBS and fund a small business. However, as an entrepreneur, you may have more opportunities (through your various networks and relationships) than many others to support early-stage companies—perhaps giving you a higher probability of generating significant tax-free profits over time.
However, to hold QSBS and get the tax benefits, you have to meet criteria including these:
Assuming the issuer and shareholder requirements are met, you’ll qualify for an exclusion from gain on the sale of the QSBS.
Important: You can still potentially benefit if you’ve held your shares for more than six months but you sell before the five-year minimum holding period. In that case, you can defer a capital gain by reinvesting the proceeds from the sale of the QSBS into another QSBS within 60 days.
In recent years, numerous once-small companies (often in the tech sector) have gone public and their shares have soared in value. This has put greater attention on the capital gains tax avoidance that can occur with QSBS. One report on QSBS in the Columbia Law Review noted that “the loss in federal tax revenue … is far greater than previously estimated, with the provision almost exclusively benefitting the wealthy.”
Compounding the controversy is a strategy that involves investors in QSBS gifting some or all of the shares to relatives. Even though those recipients didn’t invest their own money, they inherit the full tax break—meaning an additional $10 million or more in profits become tax-free. The reason: While the tax break is denied to people who purchase shares from other investors, as noted above, it remains available to people (other than a spouse) who receive the shares as gifts. There are also no limits on the number of gifts that QSBS investors can make.
The upshot: Using this approach, the big tax breaks can essentially get stacked on top of each other—enabling families to potentially save tens of millions of dollars in taxes if the shares become extremely valuable down the road. The strategy, while legal, has been the focus of some lawmakers’ efforts to rein in QSBS’s tax benefits.
Clearly QSBS can present opportunities for some business owners. But it’s an area where you need to tread carefully in order to meet the necessary requirements and stay on the right side of the rules—for your sake and the sake of any investors holding QSBS that your company issues. A qualified tax advisor and other experts can be important resources to consult if you decide that QSBS is something you want to explore.
Disclosure: Tax laws are subject to change, which may affect how any given strategy may perform. Always consult with a tax advisor.
This report was prepared by, and is reprinted with permission from, VFO Inner Circle. AES Nation, LLC is the creator and publisher of VFO Inner Circle reports.
Disclosure: The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra IS or Kestra AS. The material is for informational purposes only. It represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. It is not guaranteed by Kestra IS or Kestra AS for accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Securities offered through Kestra Investment Services, LLC (Kestra IS), member FINRA/SIPC. Investment advisory services offered through Kestra Advisory Services, LLC (Kestra AS), an affiliate of Kestra IS.
Fusion Wealth Management is not affiliated with Kestra IS or Kestra AS. https://www.kestrafinancial.com/disclosures
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