Typically, when a shareholder sells stock, any gains or losses are "capital" gains and losses. Capital gains, like other gains, must be reported as income by the shareholder. The good thing is that capital gains have a lower income tax rate than ordinary income or gains. So, when a business is sold through a stock purchase acquisition, shareholders can see significant tax savings.

There are special rules and tax treatment for gains realized on sales of small business stock. In 1993, in an effort to increase investments in small businesses, a new provision of the tax code became law. It allows a seller to exclude from income a portion of any gain realized in the sale of certain small business stock.

So, if you're thinking about selling a small business that has issued stock, it's a good idea to learn some things about this special tax treatment. The tax laws in this area can be complex. An experienced business or tax law attorney can help you here.

What Exactly Is the Special Treatment?

Under the tax code, individual taxpayers may exclude 50 percent of any gain from the sale (or exchange) of qualified small business stock if they've held it for 5 years or longer. This exclusion is not allowed to C corporations.

Qualified small business stock is stock:

  • In a qualified small business (QSB) that is a regular C corporation, as opposed to an S Corporation;
  • Was originally issued after August 10, 1993; 
  • Was acquired by the taxpayer at its original issue in exchange for money or property or as compensation for services provided to the corporation; and
  • The corporation meets the active business and qualified trade or business requirements

Typically, the special tax treatment is available only to taxpayer-shareholders who are (or were) original investors in a qualified small business. This means the taxpayer-shareholders who were the first to receive stock in the small business.

What Is a Qualified Small Business?

A qualified small business is a domestic C corporation that does not have, at the time of the issuance of stock, assets in excess of $50,000,000 and whose aggregate gross assets after the issuance of stock do not exceed $50,000,000. Aggregate gross assets is the amount of cash and the aggregate adjusted bases of other property held by the corporation.

The Active Business Requirement

The active business requirement is met if at least 80 percent of the corporation's assets are in the active conduct of one or more qualified trades or businesses. Assets used in start-up activities, research and experimental activities and in-house research expenses fall within the "active conduct" requirement.

A qualified trade or business is any trade or business other than things like:

  • A trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services or brokerage services
  • Any trade or business in which the principal asset is the reputation or skill of one or more of its employees;
  • A banking, insurance, financing, leasing, investing or similar business;
  • A farming business (including the business of raising or harvesting trees); or 
  • A business operating a hotel, motel, restaurant or similar business

Questions for Your Attorney

  • I have qualifying small business stock, but if I sell it now, I'll take a loss. Should I take the loss? Or, Should I wait and hope that the value increases so that I can take advantage of the special tax treatment for gains?
  • If I gift my qualifying small business stock to my children in will, are they entitled to the special tax treatment for gains?
  • If I failed to use the special tax treatment, how long do I have to amend my previous return?