Here are the requirements your company must meet for your shares to receive QSBS tax treatment:
- Domestic C Corporation
The business must be C corporation and domiciled in the US.
It must not have been a foreign corporation, DISC, former DICS, regulated investment company, real estate investment trust, REMIC, FASIT, cooperative, or a corporation that has made (or that a subsidiary has made) a section 936 election.
- Definition of Qualified Business
Often the primary question is whether the company meets the definition of a qualified business. A company will qualify as long as it is not one of the following:
- A business involving services performed in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any such business whose principal asset is the reputation or skill of one or more employees.
- A banking, insurance, financing, leasing, investing, or similar business.
- A farming business (including the raising or harvesting of trees).
- A business involving the production of products for which percentage depletion can be claimed (i.e. natural resources).
- A business of operating a hotel, motel, restaurant, or similar business.
At first glance, this could appear to exclude almost any business imaginable. For example, technology start-ups could be defined as engineering, while biotech could fall under the field of health.
Fortunately, the IRS has taken a narrow view of the definitions above. For example, “health” has generally been defined as serving and treating particular patients, allowing biotech companies well removed from patient cases to qualify. “Financial services” generally refers to those advising or serving particular clients, allowing fintech companies offering broad product solutions to potentially qualify as well.
As long as it is not specifically excluded under points #2 - 5 above (hotels, banks, farms, etc.), a company can qualify if it does not offer services through individual expertise. Under that standard, the following businesses would appear to qualify:
A technology company that supplies credit card readers
A biotech company that produces a kidney stone treatment
A software company that provides HR management tools
By contrast, firms of any size whose output is dependent upon the service of the individual(s) providing the expertise do not qualify. This includes consulting, architecture, financial advice, brokerage services, law, accounting, etc.
A different way to view this is customization. If each customer receives an individualized or unique solution (such as a tax return or investment portfolio), the business provides a service, and will not qualify. On the other hand, if many or all customers receive the exact same solution, the company offers a product, and the business is likely to qualify, even if the product is intangible.
Most of the QSBS-related IRS private letter rulings have centered around whether the company was a qualified business. You can find the applicable case law and private letter rulings here.
- Asset Test
As of the date the stock was issued, the business must have had gross assets of $50,000,000 or less:
- At all times after 8/9/93, and before the stock was issued
- Immediately after the stock was issued
In calculating gross assets, use the original cost (cost basis) of the assets rather than fair market value.
For software companies who receive royalties rather than business income, software royalties should be treated as an asset, and will generally be valued based upon cost basis (i.e. the amount spent developing the software).
All corporations that are members of the same parent-subsidiary controlled group are treated as one corporation.
Also, during substantially all the time you held the stock, at least 80% of the value of the corporation’s assets must have been used in the active conduct of one or more qualified businesses (defined above). Note that the corporation will automatically fail this test if 10% or more of the value of its assets (in excess of liabilities) consists of stock or securities in non-subsidiary corporations.
- Certain Purchases by Corporation of Its Own Stock
In some cases, certain transactions and redemptions can disqualify you or your stock. These situations are more likely to occur with privately-held businesses as opposed to publicly-traded companies.
Company stock purchases from you or a related person
If at any time two years prior and two years after the issuance of your QSBS shares the company purchased any of its shares from you or a related person, you may not claim QSBS treatment for such shares.
Stock buybacks
If at any time the company purchased more than 5% of its own stock, all shares issued one year prior and one year after shall not be eligible for QSBS treatment. Note that unlike the provision above, which applies to a single person, this rule applies to anyone owning such stock.
304(a) transactions
Under 1202(c)(3)(C), if any transaction is treated under section 304(a) as a distribution in redemption of the stock of any corporation, for the purposes above such corporation shall be treated as purchasing an amount of its stock equal to the amount treated as such a distribution under section 304(a).