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Consider the Tax Benefits of Investing in Qualified Small Business Stock

September 27, 2016

If you’re a long term investor, you might consider investing in qualified small business stock— it offers both tax and non-tax benefits.

Taxes should never be the main driver of investment decisions. But for high-net-worth investors, tax consequences are important to consider. After all, these taxpayers may be subject to not only the top long-term capital gains tax rate of 20% but also the 3.8% net investment income tax.

If you’re concerned about these tax rates, one alternative to consider is tax-advantaged investments. The first investment that comes to mind may be municipal bonds, but there’s another option that can both further diversify your portfolio and potentially offer more upsides — if you’re a long-term investor: qualified small business stock (QSBS).

Tax-Free Treatment Now Permanent

The Protecting Americans from Tax Hikes (PATH) Act made permanent the tax-free treatment of 100% of the gain from the sale or exchange of QSBS, as long as certain requirements have been met.

The key requirements are 1) the QSBS was acquired on or after September 28, 2010, and 2) it was held for more than five years. (A smaller exclusion is available for QSBS acquired earlier, if the five-year requirement has been met.)

To qualify as QSBS, the stock generally must have been issued by a C corporation that doesn’t own assets worth more than $50 million and that’s in an active trade or business. But additional rules apply.
The PATH Act also enhanced the attractiveness of QSBS by making permanent the exclusion of QSBS gain for alternative minimum tax (AMT) purposes — again, provided the applicable requirements are met.

Alternative: Tax-Free Gain Rollover

What if you decide you don’t want to hold the QSBS for five years? While you won’t enjoy the 100% gain exclusion on a sale before the five-year mark, you can defer the tax by investing the proceeds in other QSBS.

No tax will be due until you sell the replacement QSBS. You will recognize gain only to the extent that the amount realized on the sale is greater than the cost of any QSBS you purchased during the course of the replacement period. You have to subtract any part of that cost that was previously taken into account under Section 1045.

The amount of the deferred gain lessens the basis in the replacement QSBS; thus, any gain not recognized at that present time is not excluded, but rather deferred. The replacement stock’s holding period includes the holding period of the original stock.

For the transaction to qualify as a tax-free gain rollover, the replacement QSBS must be purchased within 60 days of selling the original QSBS.

Is QSBS Right for You?

As you can see, QSBS offers both tax and nontax benefits. But the rules are complex, and if you don’t comply with all of the requirements, the tax consequences might not be what you expect. Plus there’s a certain degree of risk with any stock investment, so it’s important to consider your risk tolerance and investing goals. Our tax professionals can help you assess whether investing in QSBS is right for you and, if it is, help ensure you reap all of the desired tax benefits.

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