Qualified small business stock can provide a beneficial exit strategy

Private equity firms have long recognized the manufacturing sector as a vital arena for investment, with the potential to significantly influence economies, industries and communities.

As we continue to see private equity firms infuse capital into manufacturing companies, one area the founders and private equity investors will focus on is their exit strategy. There is no more tax-efficient exit than one that allows a shareholder to exclude the gain arising from the sale of the company’s stock from taxable income.

That’s exactly what can happen if the stock of a manufacturing company meets the definition of qualified small business stock (QSBS) under the meaning of Section 1202. For shareholders other than corporations who own QSBS acquired after September 27, 2010, and hold that stock for at least five years, the shareholder can exclude from gain up to the greater of $10 million or 10 times the shareholder’s basis in the stock upon a sale of that stock.

To qualify for QSBS, the manufacturing company must meet certain criteria in accordance with Section 1202, which includes:

1. Domestic C corporation: The company must be a domestic C corporation on the date of original stock issuance.
2. Active business requirement: At least 80% (by value) of the assets of the corporation must be used by the corporation in the active conduct of one or more “qualified trades or businesses.”
3. Holding period: The stock must be held for at least five years.
4. Aggregate gross assets: At all times from August 9, 1993, through the date of issuance, the aggregate gross assets of the corporation (or any predecessor) must not have exceeded $50 million, and immediately after the date of issuance the aggregate gross assets of the corporation must not exceed $50 million.

By investing in QSBS, shareholders can potentially exclude up to 100% of their capital gains from federal taxes when they sell the stock. This can result in substantial savings for both the company and its investors.

Some specific tax advantages that QSBS offers

• Exclusion of gain upon sale: The most common benefit associated with QSBS is the ability to exclude from federal tax up to $10 million of capital gains or 10 times your cost basis, whichever is higher. Federal tax includes alternative minimum tax and net investment income tax.
• Lower capital gains tax rates: Any excess capital gains after Section 1202 exclusion are potentially subject to the preferential long-term capital gains tax rates plus 3.8% net investment income tax. For QSBS issued before February 18, 2009 (50% gain exclusion), and between February 18, 2009, to September 27, 2010 (75% gain exclusion), the gain not excluded is generally subject to the federal income tax rate of 28% rather than the preferential long-term capital gains tax rates.
• Tax-free treatment in certain states: Shareholders may also exclude up to 100% of their capital gains from certain state income taxes when they sell QSBS stock. Shareholders may accomplish this by establishing residency in a state with no income tax, no capital gains tax or conforming to the federal treatment for QSBS.
• Potential for deferral of taxes: In some cases, shareholders may be able to defer taxes on gains from the sale of QSBS by reinvesting in another QSBS within a certain time frame under Section 1045. Section 1045 allows a shareholder who has held QSBS for at least six months to roll the proceeds from a sale into replacement QSBS. To the extent the proceeds are reinvested within 60 days of the sale of the relinquished QSBS, the gain on the sale will be deferred. If the shareholder can get to a combined five-year period between the relinquished and replacement QSBS, a Section 1202 exclusion will be available upon the sale of the replacement stock.

How Wipfli can help

QSBS can offer manufacturing companies significant tax advantages that should not be overlooked. By understanding the criteria for qualification, you can maximize the benefits of QSBS for both your company and private equity investors. Speak with one of our dedicated professionals today to see how your company can get started.