How To Save Millions of Dollars in Taxes When You Sell Your Business

Summary/TL;DR

If the stock of a business qualifies as Qualified Small Business Stock (QSBS), then it is eligible for massive tax benefits when it is sold, oftentimes saving the owners of the stock millions in taxes. To qualify, there are various requirements that must be met when the stock of the company is issued and throughout the shareholder’s ownership of the stock, primarily that the business in question is organized as a domestic C Corporation for at least 5 years. When pursued alongside the guidance of a qualified professional, QSBS is arguably the most powerful tax-savings tool at one’s disposal.

Introduction – What is Qualified Small Business Stock (QSBS)

Qualified Small Business Stock (QSBS) is the stock of any business that meets the requirements of Section 1202(a) of the tax code. These requirements fall into two categories – requirements at the time of stock’s issuance, and requirements throughout the stock’s ownership. Furthermore, only certain kinds of businesses can qualify.

Section 1202 is arguably one of the greatest tax-saving provisions currently in existence. If a business’ stock is QSBS at the time it is sold, then 100% of the gain incurred from the sale is excluded from taxation, within certain limitations.

If you plan on selling your business, you need to understand Section 1202 and whether it’s right for you.

Eligible Businesses

Only “qualified trades or businesses” (QTBs) are eligible for QSBS status. Here’s a very helpful definition of a QTB from an article on The Tax Advisor:

In general, these are the same requirements for a business to be eligible for the Qualified Business Income (QBI) Deduction. If you are eligible to claim this deduction on your return, then chances are you are eligible to qualify as a QBS.

The best place to start when trying to determine if your business qualifies is to ask your CPA. If they don’t understand what you’re asking, then you probably need a new CPA who has experience guiding business owners through Section 1202.

Issuance Requirements

At the time the stock of the business is issued, the following requirements must be met:

C Corporation Requirement

First, the business must be organized as a domestic C Corporation. This does not mean that your business, which is currently organized as a Partnership or S Corporation, cannot ever qualify as a QSB. This only requires that any such business first be reorganized as a C-Corp and have all its stock reissued.

Aggregate Gross Assets Requirement

At no time from August 9, 1993 through the date of issuance may the aggregate gross assets of the business have exceeded $50,000,000. They also may not cross this level immediately after the date of issuance.

After the stock is issued, aggregate gross assets may exceed $50,000,000 without “tainting” any previously issued stock. However, this business will forever be excluded from QSB eligibility for any stock issued after such a time.

Original Issuance Requirement

The final “issuance requirement” is that QSBS must be obtained through “original issuance”. In other words, the stock must be acquired directly from the issuing corporation and not purchased from an old shareholder. Stock that was acquired at original issuance and is subsequently gifted or inherited by another retains its “original issuance” status.

Ownership Requirements

For “substantially all” of the shareholder’s holding period, the following requirements must be met:

C Corporation Requirement

The stock of the business must not only be issued as stock of a domestic C Corporation, but it also must be a C Corporation for “substantially all” of the shareholder’s holding period. The definition of “substantially all” is somewhat loose due to lack of guidance from the IRS, and the specifics won’t be discussed here. For now, be aware that the minimum amount of time for this requirement to be met is 5 years.

While a C-Corp election could result in higher taxes for the 5 years it takes to obtain Section 1202 qualification, it is often well worth the additional “cost” in exchange for what will amount to a tax-free business sale for many. Furthermore, upon the sunsetting of the Tax Cuts and Jobs Act in 2026, it’s very likely that C-Corps will be more common anyway due to the permanence of the cut in the corporate tax rate put into place by that law.

Active Business Requirement

Here’s a concise definition of this requirement from The Tax Advisor:

during substantially all of the shareholder’s holding period, the corporation must be an “eligible corporation,” and at least 80% (by value) of the assets of the corporation must be used by the corporation in the active conduct of one or more “qualified trades or businesses [defined above].”

An eligible corporation is simply “ any domestic corporation other than a DISC (Domestic International Sales Corporation) or former DISC, a regulated investment company, real estate investment trust, REMIC, or a cooperative.”

Don’t Try This At Home!

Section 1202 is very complex! Underneath the narrow surface of this blog post lies a web of tests, best practices, and other intricacies that make pursuing QSBS eligibility something that should only be done in the council of a professional. Furthermore, the law changes frequently, and sometimes it does so in a dramatic fashion. A well-educated and proactive professional will not only help you navigate the complexities of Section 1202, but will also help you stay abreast of these legislative changes to ensure your eligibility is maintained and your tax-savings is maximized.