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Article highlights:
Qualified Small Business Stock offers significant tax benefits for investors in eligible small businesses. By understanding the QSBS exemption and employing strategies like QSBS packing, investors can increase their asset basis and save on taxes. In this guide, we will explain QSBS packing, the QSBS exemption and various ways to ‘pack’ QSBS investments to maximize tax savings.
QSBS refers to stocks issued by small C corporations that qualify under Section 1202 of the Internal Revenue Code. To be considered a Qualified Small Business (QSB), a company must have gross assets not exceeding $50 million before and immediately after the stock issuance.
The QSBS exemption allows investors to exclude a portion or all of the capital gains from the sale of QSBS from federal income tax, provided certain criteria are met:
QSBS packing is a strategic approach investors use to increase the basis of their QSBS shares and maximize their QSBS exemption. The key rule that QSBS packing is built around is the limit on the amount you can claim in QSBS exemption is the lower of:
Its important to know these limits apply on a per-company basis, so you can potentially claim QSBS exemptions for multiple companies, each with its own limits. Now how does this tie to QSBS packing?
There are two primary methods for QSBS packing:
How does this work?
Step 1: An investor invests $4 million of cash in a C corporation.
Step 2: The investor’s basis for the annual exclusion calculation is determined by referencing the FMV of the assets contributed, which is $4 million.
Step 3: The increased basis of $4 million allows the investor to exclude up to $40 million (10 x $4 million) in capital gains from taxation.
How does this work?
Step 1: A founder sells half of their stock for $40 million that has a basis of $5,000 and would only be able to exclude $10 million with QSBS.
Step 2: The founder sells another grant of the same stock with a high-basis during the same tax year, such as from the exercise of stock options where they paid $2 million for the stock.
Step 3: The total basis of QSBS sold during the year is now $2.005 million ($5,000 original basis + $2 million from stock options).
Step 4: The increased total basis of $2.05 million allows the founder to exclude up to $20,050,000 in federal capital gains taxation
By using this strategy, the founder effectively doubles their Section 1202 exclusion by packing their basis, taking advantage of the annual exclusion rather than just the $10 million exclusion.
QSBS packing is a powerful strategy for investors seeking to maximize their tax savings when investing in small businesses. By understanding the QSBS exemption and employing QSBS packing methods, investors can increase their basis in the assets and benefit from substantial tax savings. It is essential to consult with a qualified tax professional when implementing these strategies to ensure compliance with tax laws and regulations. The step-by-step examples provided above illustrate how QSBS packing works in practice, helping investors make informed decisions about their investments and tax planning.
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