The only thing better than exiting an investment at a sky-high valuation is paying no tax on your exit. This seems to violate the tax principle that, if it’s too good to be true, it is. However, it is possible to pay no tax on exit of an investment. With proper tax planning, you may be able to secure yourself the mythological “free lunch.”

Qualified Small Business Stock (QSBS)

The Qualified Small Business Stock (“QSBS” under IRC Section 1202) rules were enacted in 1993 but did not receive much attention for many years due to minimal gain exclusion when the dust finally settled.¹ This rule allows individuals who sell C corporation stock to pay less federal and (likely state) tax on gain on sale. For stock acquired after September 27, 2010, there may be no tax at all on the gain, including the irksome net investment income tax (NIIT).²

Private Equity and the QSBS Opportunity

Private equity as an industry has historically ignored this tax gem because it only applied to individuals. Now, however, private equity funds are forming special purpose C corporations to make their investments with an eye towards a tax-enhanced exit. A catalyst for this strategy was the 21% reduced federal corporate income tax rate enacted as part of the 2017 Tax Jobs & Cuts Act, which is not subject to the sunsetting rules for various other TCJA provisions.³

Requirements and Structuring for QSBS Benefits

To form an investment vehicle that can take advantage of this QSBS tax benefit, the vehicle must:

• Be a C corporation or an LLC electing to be taxed as a C corporation
• The corporation must be actively engaged in a qualified trade or business (excluding professional services [e.g., health, law, accounting, engineering], financial services, farming, oil & gas, hotels, and restaurants)
• Must not have more than $50 million of gross asset value immediately before or after the stock is issued
• Be owned by individuals who received the stock from the corporation at its original issuance in exchange for cash, property, or services
• Must be held for more than five years

A selling shareholder can only avoid tax on up to $10 million or 10 times the shareholder’s tax basis in the stock, whichever is greater. While this rule only applies to sale by individuals, this benefit is available to partners in a partnership or shareholders in an S corporation if the investment is properly structured.⁴ As a result, the fund can be structured as a partnership (or LLC taxed as a partnership) that forms the C corporation investment vehicle.

Documentation and Compliance

Because of the technical requirements for qualifying for QSBS treatment, it makes sense to memorialize the qualifications at the time of issuance and have a tax basis balance sheet to confirm that the gross value of the assets did not exceed the $50 million limit. It may also help to have a tax opinion or memorandum supporting the investment. Note, the $50 million limit does not apply to any future growth in the value of the assets unless a new valuation is required due to a subsequent issuance of shares intended to qualify as QSBS.

Example of a QSBS Benefit

To illustrate how this rule works, assume 10 individual partners each invest $2 million into a partnership that purchases QSBS stock for $20 million. If the partnership sells the QSBS after five years for $200 million, the 10 investing partners would not pay federal income tax on exit. This is because each partner has a $2 million tax basis in their QSBS and is eligible to exclude gain equal to 10 times their basis (i.e., $20 million).

Alternative Option: Section 1045 Rollover

For those taxpayers who have not held their QSBS for the requisite five years, there may be another option for a tax-free exit. Code Section 1045 allows for a “rollover” of taxpayer proceeds from the sale of QSBS (held for more than six months but less than five years) into a qualifying investment. If structured properly, the taxpayer’s gain on the sale of the first QSBS is deferred to the extent the sale proceeds do not exceed the purchase price of the “replacement” QSBS and the taxpayer’s basis and holding period in the original QSBS that was sold carries over to the replacement QSBS.

To meet the tax-deferred rollover requirements of Section 1045:

• The original QSBS is owned for at least 6 months prior to the sale
• The proceeds of the sale of the original QSBS must be reinvested into a “replacement” QSBS within 60 days of the original QSBS sale
• The taxpayer elects for rollover treatment for the sale of the QSBS on their tax return

Final Thoughts

A dark cloud hangs over this tax-free exit strategy. Congress has raised the possibility of eliminating a large part of the benefit for those with gross income of $400,000 or more.⁵

While it is a rare case indeed in the tax world to have the opportunity to exit an investment tax free, Section 1202 may provide just such an opportunity. Middle-market private equity participants would be wise to investigate potential acquisition and exit planning opportunities to take advantage of this benevolent rule.

¹ All section references are to the Internal Revenue Code of 1986, as amended.

² The NIIT is a 3.8% tax on investment income for those with income over $250,000 (married filing jointly). See Section 1411 and IRS Form 8960.

³ P.L. 115-97 (November 2, 2017).

⁴ Section 1202(g)(1). Also applies to RICs and common trust funds.

⁵ See Karachale, “The Future of Section 1202 and the Qualified Small Business Stock Exclusion: Planning Around Potential QSBS Repeal,” 62 Tax Management Memorandum Number 23, page 297 (November 8, 2021). Under the Neal proposal, the 75% and 100% exclusion would not apply to sellers with adjusted gross income of $400,000 or more. However, the benefits would continue to apply to those with written binding agreements in effect prior to the proposal’s effective date.