Harry Potter and the Chamber of Secret QSBS Exclusions

August 29, 2022Article

Are your shareholders leaving money on the table? Certain tax planning strategies, much like magic spells in the Wizarding World of Harry Potter, require some pre-ordained incantations in order to bring them to life. The exclusion of gain from the sale of Qualified Small Business Stock (“QSBS”) under Section 1202 is one of those magical spells that has the ability to make millions in taxable liability vanish. The rules contained in Section 1202 of the Internal Revenue Code allow a taxpayer to potentially exclude up to $500,000,000 in taxable income from the sale of QSBS (if planned correctly).

To determine whether stock issued by a corporation may qualify for QSBS treatment, a taxpayer should ask themselves the following questions:

  • Is the Company taxed as a C-corporation?
  • Is the Company actively engaged in a trade or business?
  • Does the Company have less than $50,000,000 in gross assets (including goodwill if converted from an LLC to a C-corporation) at the time it issued such stock?
  • Is the Company engaged in a trade or business other than the trade or business of personal services such as an accountant, lawyer, doctor, consultant, or athlete?
  • Is the Company engaged in a trade or business other than operating a hotel, motel, restaurant, or similar business?
  • Is the Company engaged in a trade or business other than investing, leasing, financing, banking, or other similar business?
  • Are less than 10% of the Company’s assets compromised of real estate or stock of an unrelated company?

If the answer to each of the questions above is “yes”, and such QSBS was held for 5+ years at the time of the disposition, the shareholders of such company may be eligible to exclude the greater of $10,000,000 or 10x the basis of their stock (assuming all other requirements were met as well). There are certain limitations on the exclusion for QSBS issued prior to 2010. [1]

To help illustrate the benefit of QSBS over the course of a company’s lifecycle, we have included the following example, illustrating the tax savings for a new company earning $100k annually, which is sold for $2M at the end of year 5:

LLC with no QSBS C-Corporation with QSBS
Entity level tax on $100,000 of annual profits from each years 1-5 $0 $105,000[2]

Shareholder level tax on $100,000 of profits from each years 1-5

$150,000[3] $118,500
Total tax owed from years 1- 5 from operations $150,000 $223,500
Tax from selling the Company for $2,000,000 $600,000 $0
Total tax owed over the life of the business $750,000 $223,500

The example above illustrates that one layer of tax is not always better than two.

It should be noted that there are certain actions a company can take that may make the company’s stock ineligible for QSBS treatment. Taxpayers should avoid the following when looking to preserve QSBS status:

  • Buying the stock from another shareholder instead of from the Company,
  • Contributing the QSBS to a partnership,
  • Redemptions by the Company two years before or two years after the issuance of QSBS,
  • Performing services adjacent to the prohibited services, such as medical research or a Fintech app, without obtaining an opinion from tax counsel,
  • Failing to hold the stock 5 years prior to disposition,
  • Failing to rollover under Section 1045 if the QSBS is sold prior to the 5-year mark,
  • Failing to know whether the Company’s SAFEs are treated as equity or a prepaid contract for tax purposes, and
  • Waiting too long to convert from an LLC to a C-corporation when planning to maximize QSBS exclusion, and accidentally exceeding the 50m gross asset test.[4]

If a shareholder qualifies for a QSBS exclusion, no documentation is required to be attached to the shareholder’s tax return to claim the exclusion. Rather, taxpayers must simply know to exclude the appropriate amount of income from the sale of their QSBS. It is also imperative that taxpayers maintain sufficient records to support their position if audited.

Although this article covers the basics, there are additional nuances in qualifying for and claiming a QSBS exclusion. For additional information or questions concerning the information covered in this article or any other issues related to QSBS or Section 1045 rollovers, please contact any of the authors or your usual Greenberg Glusker LLP contact.


[1]       Generally, 50% of the gain can be excluded for QSBS issued after August 10, 1993, and before February 18, 2009; 75% of the gain can be excluded for QSBS issued after February 17, 2009, and on or before September 27, 2010; and 100% for QSBS issued after September 27, 2010.

[2]       Based on the current 21% corporate tax rate.

[3]       This assumes a 30% rate (37% is the max tax rate with a 20% QBD coming out to roughly 30% individual tax rate).

[4]       Generally self-generated goodwill is not counted for purposes of the $50M gross asset test. However, when a company converts from an LLC to a C corporation, the goodwill generated during the time as an LLC is valued at FMV upon contribution for purposes of the gross asset test, and may therefore cause a company to exceed $50M in gross assets, and fail to qualify as a qualified small business.