How a Seller Can Enjoy Tax-Free Growth: a QSBS Primer

Sometimes the answers are right in front of us if we view a problem from a different angle. The problem I’m referring to is the tax bite small business owners face when it comes time to sell their businesses. And while it is true that the only certainties in life are death and taxes, there are still powerful tax incentives for sellers if you know where to look for them.

One answer to counteracting the tax burden associated with a business sale is known as the Qualified Small Business Stock (QSBS) gain exclusion and it is available to sellers willing and able to roll forward a portion of their business equity into the buyer’s acquiring business entity. Also known as Section 1202 stock after the applicable section of the Internal Revenue Code, this associated tax incentive has been available to qualifying business owners since it was first introduced in the Revenue Reconciliation Act of 1993. The exclusion was designed to encourage investment in small businesses. Although the associated tax savings have been around since 1993, a subsequent amendment increased the tax exemption to apply to 100% of the gain if the QSBS has been issued after September 27, 2010. This can result in a tremendous windfall for holders of the stock.

What does it mean for sellers in the heating and cooling industry? In short, sellers who are given the option by the buyer to participate in an ownership stake of the company purchasing the assets through what is called an equity roll-over can defer taxes on the portion of the sale price they invest in the new entity and then watch their continuing equity grow capital gains tax-free if certain conditions are met. That’s right – potentially zero tax bite on the growth in value of the QSBS, saving the seller (who is now the investor) the normal 23.8% capital gains tax plus state capital gains tax. This generous exclusion applies to the greater of $10 million or 10 times the adjusted cost basis of the issued stock. Imagine what this investment can mean if your company’s buyer provides you the opportunity to roll over some of your equity into the new company? As an example, $2 million in rolled equity could grow to several million, and as high as $20 million (i.e., 10 times the basis) – with no tax on the gain! Talk about a powerful incentive to invest.

Obviously, there is a fundamental requirement at play here: the seller must work with the right buyer. Most sellers over the years have defaulted to a deal with a competitor or regional consolidator because that was the only realistic option available to them. That approach generally will not work for this tax benefit as most strategic buyers do not offer the opportunity to roll over equity. But interest from financial buyers (such as private capital and private equity firms) in a growing segment of the lower middle market retail heating and cooling industry has opened up a more collaborative avenue for sellers interested in remaining in the deal, even after taking a meaningful amount of chips off the table for retirement or other ventures. As the value of the purchased entity grows from the financial strength and expanded management team of the financial buyer, the QSBS of the seller sits beside the stock of the private capital investors and continues to appreciate.

The potential tax benefits to you as a seller are significant, but the requirements and definition of a qualified small business are somewhat restrictive. The basics include:

The issuer of the QSBS must be a C-Corporation in the United States
QSBS shares must be held for a minimum of 5 years before the exemption applies
At the time of stock issuance, the company’s assets must be less than $50 million at all times after August 1993 or for the period the business is active (if the asset value later exceeds $50 million, it doesn’t disqualify the previously issued stock)
The company must be an active business at all times (i.e., not a holding company)
Generally, the business type cannot be personal services banking, insurance, financing, leasing or investing, a real estate company, hotel, restaurant or mining company (see 26 U.S. Code 1202 (e)(3) for a more specific listing of excluded business types)
QSBS must be acquired in exchange for money or property or as pay for services
During the holding period, it must be shown that more than 80% of the corporate gross assets were used in the active conduct of the business

These are the QSBS highlights and you should consult with your accountant and attorney before structuring your deal to avoid moves that could disqualify your stock from eligibility and to understand what you’ll want to document. The key takeaway here is that by undertaking a sale with a financial buyer a seller has options that strategic buyers typically do not offer. As you plan your eventual exit, exploring your avenues fully can position you for a second potentially substantial windfall. If you have the opportunity, let the tax code work in your favor for a change.

Disclaimer: This article has been prepared for information purposes only. Notch Capital does not provide tax, legal or accounting advice. You should consult your professional advisors before engaging in any transaction.