Scenario: A Founder and Qualified Small Business Stock

This page describes a composite hypothetical. It is not a real client or a real result. The exclusion rules have changed recently and are described in general terms, so confirm current requirements before relying on anything here.

The Scenario in Brief

A founder started a software company as a C corporation several years ago and holds founder shares. A buyer has expressed interest in acquiring the company's stock. The founder has heard about a provision that may exclude some or all gain on qualified small business stock. The founder asks an advisor whether the shares might qualify and how to test it.

Assumptions Used

• The founder received shares at incorporation in exchange for a small cash payment and services.
• The company is a domestic C corporation that has been one since formation.
• The company's business is developing and licensing software, which is assumed to be a qualified trade or business.
• The company's aggregate gross assets were well below the applicable limit at the time the shares were issued.
• The founder's stock basis is 10,000 dollars.
• The buyer proposes a stock purchase in which the founder would receive 4,000,000 dollars.
• The holding period is assumed to satisfy the minimum for some level of exclusion, but the applicable percentage depends on the date of issuance.

The Advisor's Checklist

The advisor would go through the requirements in order:

1. Domestic C corporation. The issuer must be a C corporation, and it must meet the requirements during substantially all of the holding period.
2. Original issuance. The shares must have been acquired from the company, in exchange for money, property, or services.
3. Active business. At least 80 percent of the company's assets, by value, must have been used in the active conduct of one or more qualified trades or businesses during substantially all of the holding period.
4. Excluded fields. The business must not be in an excluded field, such as many professional services, financial services, farming, mining, or hotel and restaurant businesses.
5. Asset test. Gross assets must not have exceeded the applicable limit at the time of issuance and immediately after.
6. Holding period. The shares must have been held for the required period.
7. Redemptions. Certain redemptions by the company around the time of issuance can disqualify shares.

Worked Arithmetic

Suppose the exclusion applies at the maximum percentage and the per-taxpayer limit is high enough to cover the gain. The gain on sale would be 3,990,000 dollars, the price minus basis. If all of it were excluded from federal income tax, the federal tax on that gain would be zero, compared with roughly 798,000 dollars at an assumed 20 percent capital gain rate. If instead only a percentage of the gain were excluded, or if the per-taxpayer limit were lower than the gain, the taxable amount would be larger. For example, if the limit were 1,000,000 dollars per taxpayer, only 1,000,000 dollars of gain could be excluded, and the remaining 2,990,000 dollars would be taxed under the ordinary capital gain rules. These figures are hypothetical, and the actual limit and percentages depend on the date the shares were issued and the law in effect.

What Could Go Wrong

The advisor would discuss risks that could undermine eligibility. If the company had ever redeemed stock from the founder or a related party in a way that violated the rules, the shares might not qualify. If the company's assets included substantial investments unrelated to the business, the active business test might fail. If the company had been an LLC taxed as a partnership before converting to a corporation, the shares issued on conversion might raise valuation and holding period questions. State tax may not follow the federal exclusion.

Documentation

The advisor would ask for the incorporation documents, the stock ledger, board minutes approving the issuance, the balance sheet at issuance, and financial statements for the holding period. The buyer will likely ask for these as well during due diligence.

Scenario Variations Worth Considering

If the buyer wanted to buy assets instead of stock, the exclusion would not apply in the same way, since the company would sell the assets and pay tax. If the founder had gifted some shares to family members or trusts, each holder might have a separate limit, with technical requirements. If the founder held the shares for a shorter time, a lower exclusion percentage or none might apply.

Risks and Limits

• The exclusion has many technical requirements and can be lost by facts that are hard to fix later.
• Legislation has changed limits and percentages for stock issued on or after certain dates.
• State tax may differ.
• A buyer may require indemnification if eligibility is uncertain.

What This Scenario Teaches

Qualified small business stock treatment starts at formation and depends on facts that accumulate over years. It is an area where early planning and documentation matter far more than late efforts to qualify.

Questions to Bring to Your Advisor

1. Do my shares meet each requirement, and what evidence do I have?
2. What percentage and limit apply based on the issuance date?
3. How would a sale structure change the result?
4. What state tax would apply?

Educational purposes only. This page is an illustrative educational scenario, not tax, legal, or accounting advice, and it does not describe a real client or a real result. Tax laws change and outcomes depend on individual facts, so consult a qualified professional before acting. No result is guaranteed.