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Unlocking Tax-Free Growth with Qualified Small Business Stock · Bennett Thrasher Presents: Beyond The Ledger

• 0:08
  SPEAKER_00: Welcome back to Beyond the Ledger, where we go beyond the numbers to explore the strategies, risks, and opportunities shaping today's business landscape.
• 0:17
  SPEAKER_00: I'm your host, Shard A Layfield.
• 0:19
  SPEAKER_00: In this episode, we're diving into one of the most important tax planning opportunities available to founders and investors today: Section 1202 and qualified small business stock, also known as QSBS.
• 0:33
  SPEAKER_00: As more companies focus on growth, investment, and long-term exit strategies, understanding how these rules work can create significant tax saving opportunities.
• 0:44
  SPEAKER_00: But navigating the requirements and potential pitfalls is critical.
• 0:49
  SPEAKER_00: Joining us today is Lauren Brown, a senior manager in Bennett Thrasher's commercial tax practice, where she specializes in strategic tax planning and complex business tax matters for growing companies and their stakeholders.
• 1:02
  SPEAKER_00: Today we're going to be breaking down the fundamentals of Section 1202, recent OBBBA related changes, common traps businesses should avoid, and key planning strategies founders, investors, and advisors should be considering now to better position themselves for future success.
• 1:20
  SPEAKER_00: Thanks for being here today.
• 1:21
  SPEAKER_00: I'm excited to get into the conversation.
• 1:24
  SPEAKER_00: Thank you.
• 1:25
  SPEAKER_00: And I'm sure our audience will definitely learn a lot today.
• 1:28
  SPEAKER_00: So Section 1202 has become one of the most talked-about um tax planning opportunities for founders and investors over the last few years, especially as companies look towards growth, exits, and long-term wealth planning.
• 1:44
  SPEAKER_00: So, what exactly is Section 1202 and why has qualified small business stock become such an important strategy for business founders and investors today?
• 1:54
  SPEAKER_01: Yeah, so Section 1202 is a very powerful tax benefit for founders, investors, and small businesses.
• 2:02
  SPEAKER_01: It's probably one of the most beneficial for small business investors out there in terms of uh tax planning strategies.
• 2:10
  SPEAKER_01: Um essentially, it it can provide either a partial or full exclusion of the gain on the sale of qualified small business C corporation stock upon exit if all the requirements are met.
• 2:22
  SPEAKER_01: And we'll get into the requirements a little bit later on.
• 2:25
  SPEAKER_01: But it's it's a it's a really huge tax planning tool and something that all investors in small businesses should be aware of.
• 2:32
  SPEAKER_01: And then as you mentioned, the changes recently from the One Big Beautiful bill out from last year have had a huge impact and have kind of started more recent discussions about um 1202 as well, and we'll get into those as well.
• 2:43
  SPEAKER_00: Thank you.
• 2:44
  SPEAKER_00: Because I was gonna say, I'm sure there's a lot more things that are popping up now that they didn't pop up later for earlier on.
• 2:50
  SPEAKER_00: Okay, so a lot of businesses, business owners hear about QSBS after the fact, and sometimes when they're already preparing for a transaction or liquidity event.
• 3:01
  SPEAKER_00: So at what stage should founders and investors really start thinking about Section 1202 planning to maximize the potential benefits?
• 3:10
  SPEAKER_01: Yeah, so it's important to think about it all along from the purchase of the stock or the formation of the company all the way through toward to the exit event.
• 3:20
  SPEAKER_01: Um however, as you mentioned, if if companies find out about it later or are unaware initially, it's not too late.
• 3:27
  SPEAKER_01: It's just important to um, you know, consult with a tax advisor, really dig into the qualifications, because as we'll get into, the requirements can be pretty complex.
• 3:36
  SPEAKER_01: And so you just want to make sure that you're meeting the requirements for Section 1202, both initially and throughout the whole journey through until the sale of the stock, because there are certain traps that can happen later on that might um disqualify the business from Section 1202, and you just want to make sure you're aware of that from the time you find out about Section 1202 and are trying to meet the requirements.
• 3:59
  SPEAKER_00: And now, ask this really quick, is there a point where it is too late?
• 4:05
  SPEAKER_01: Well, we'll get into the stock holding period a little later on.
• 4:09
  SPEAKER_01: Um there are some situations where because you want to sell the stock at a certain point and you haven't held the stock long enough, or if your business is has tripped up some of the other requirements accidentally, or if you're if if the company has gotten too large over time and therefore doesn't no longer qualify.
• 4:30
  SPEAKER_01: So there's a lot of traps in there that you have to be aware of.
• 4:34
  SPEAKER_01: It depends on the situation, I guess.
• 4:36
  SPEAKER_00: Okay.
• 4:36
  SPEAKER_01: There are some situations where yes, it may be too late.
• 4:39
  SPEAKER_00: Okay.
• 4:39
  SPEAKER_00: Thank you.
• 4:40
  SPEAKER_00: I just had to throw that in there a little bit.
• 4:42
  SPEAKER_00: Okay, so one of the biggest misconceptions around QSBS is that simply owning stock in a startup automatically qualifies someone for the exclusion.
• 4:52
  SPEAKER_00: Can you walk us through some of the core statutory requirements that have to be met in order for stock to qualify under Section 1202?
• 5:00
  SPEAKER_01: Yes, so we will walk through kind of at a high level because as I mentioned, it's highly technical.
• 5:05
  SPEAKER_01: There's a lot of complicated requirements, but kind of at a high level, we'll walk through the requirements.
• 5:09
  SPEAKER_01: Got it.
• 5:10
  SPEAKER_01: In general, the investor in the stock cannot be a corporation.
• 5:13
  SPEAKER_01: So the investor in the stock can be an individual partnership, S corporation, or you can hold the stock through an S corporation or a partnership, an estate, a trust, but not a corporation.
• 5:25
  SPEAKER_01: Um the stock itself must be in a domestic C corporation.
• 5:30
  SPEAKER_01: So the company can have overseas activity, but it must be incorporated in the United States.
• 5:36
  SPEAKER_00: Okay.
• 5:37
  SPEAKER_01: So that's that kind of can cause some complications in certain situations when you talk about finding out too late about 1202, like if you're organized if your business is organized as a partnership or an S corporation.
• 5:48
  SPEAKER_01: It's not necessarily too late.
• 5:50
  SPEAKER_01: You can convert the stock to a qualifying C corporation stock, but you've kind of lost out on some of the holding period there.
• 5:57
  SPEAKER_01: So it is possible to convert if you are organized as a different type of entity.
• 6:02
  SPEAKER_01: But in but the requirement is the stock must be held in a C corporation.
• 6:07
  SPEAKER_01: Um the business itself needs to be in certain certain types of trades or businesses.
• 6:13
  SPEAKER_01: There are certain industries that don't qualify for Section 1202.
• 6:16
  SPEAKER_01: So this is a really key requirement that businesses need to look at initially just to determine okay, am I even in the type of business that would qualify for that?
• 6:26
  SPEAKER_01: Um in general, professional services don't qualify, banking, certain brokerage type services, real estate.
• 6:34
  SPEAKER_01: Um there's a whole host of industries that actually do not qualify for Section 1202.
• 6:39
  SPEAKER_00: Okay.
• 6:39
  SPEAKER_00: Are there some top ones that do?
• 6:42
  SPEAKER_01: Um well, in general, manufacturing, technology, anything that you kind of think of as more your active trader business, as opposed to a type of business like Benethrasher, where the primary asset of the company is the professional qualifications of the employee, one or more employees.
• 7:00
  SPEAKER_01: So you're talking about something where, you know, more like along the lines of manufacturing and technology.
• 7:05
  SPEAKER_01: And the the statute is written more in terms of what doesn't qualify than what does qualify.
• 7:10
  SPEAKER_01: And there's a lot of gray areas.
• 7:11
  SPEAKER_01: Healthcare is another big area that does not generally qualify for Section 1202, but there's a lot of gray areas.
• 7:20
  SPEAKER_01: So it's definitely something if you think like you may be sort of on the edge of qualifying or you're not really sure if your industry industry qualifies, um, it'd be important to consult a tax advisor.
• 7:31
  SPEAKER_00: Thank you.
• 7:32
  SPEAKER_00: Okay.
• 7:33
  SPEAKER_00: So we're seeing more conversations around recent legislative updates and how they could expand planning opportunities for taxpayers.
• 7:40
  SPEAKER_00: So, what are some of the OBBBA related changes to Section 1202?
• 7:45
  SPEAKER_00: And how do those updates potentially benefit founders, investors, and growing businesses?
• 7:51
  SPEAKER_01: Yes, definitely a great question.
• 7:53
  SPEAKER_01: Um and as mentioned earlier, Section 1202 is an incredible tax um savings opportunity for investors in small businesses.
• 8:00
  SPEAKER_01: And the OBBBA made it even more so, more generous, more flexible.
• 8:06
  SPEAKER_01: Basically, there were three core changes that were enacted as part of the OBBBA.
• 8:13
  SPEAKER_01: And as part of this, I'll get into some of the more some of the core requirements of Section 1202.
• 8:21
  SPEAKER_01: Um so one of the changes, and this is a requirement that I didn't mention earlier, but the holding period of the stock.
• 8:27
  SPEAKER_01: In general, the investor in the stock is required to hold the stock for five years before they get any exclusion.
• 8:33
  SPEAKER_01: Okay.
• 8:34
  SPEAKER_01: That was the historical qualification prior to the OBBBA.
• 8:39
  SPEAKER_01: Now, under the new legislation for stock issued after July 4th, 2025, there's kind of a phase in of that holding period requirement.
• 8:47
  SPEAKER_01: So if you hold the stock for three years, you get a 50% exclusion if all other qualifications are met, obviously.
• 8:53
  SPEAKER_01: Okay.
• 8:53
  SPEAKER_01: If you hold the stock for four years, you get 75%, and then the five years, 100% still applies.
• 8:59
  SPEAKER_01: So it just provides more flexibility for investors who may have invested in the company a little later on in the company's growth and the, you know, want to sell the stock quicker.
• 9:09
  SPEAKER_01: So they they only have to wait three years as opposed to five years.
• 9:12
  SPEAKER_00: Okay.
• 9:13
  SPEAKER_01: Another key change was um Section 1202 has a requirement related to the tax basis and the assets, just that kind of qualifies the business as a quote unquote small business.
• 9:25
  SPEAKER_01: Historically, that's been tax basis, aggregate tax basis basis in the assets of$50 million.
• 9:31
  SPEAKER_01: The OBBA change updated that to or increased that to$75 million.
• 9:37
  SPEAKER_01: So um, and also indexed it for inflation going forward, which it hasn't been indexed for inflation in the past.
• 9:43
  SPEAKER_01: So it just creates a greater opportunity for larger startup type businesses to qualify for Section 1202.
• 9:51
  SPEAKER_01: Um and the third key change is another issue.
• 9:56
  SPEAKER_01: So section the way Section 1202 works and the exclusion of the gain is based on um you're you're able to exclude up to$10 million or 10 times your basis in the stock.
• 10:09
  SPEAKER_01: Okay.
• 10:09
  SPEAKER_01: That's the historical requirement over time.
• 10:12
  SPEAKER_01: It's all since I think 2010, it's been 10 times your basis or$10 million, the greater of that amount is the amount that you can exclude from the gain.
• 10:21
  SPEAKER_01: Under the OBBBA, they expanded that to$15 million or 10 times your basis.
• 10:27
  SPEAKER_01: So it just provides a greater exclusion as well.
• 10:30
  SPEAKER_01: So it really expanded the ability for businesses to qualify for Section 1202.
• 10:36
  SPEAKER_01: Yeah.
• 10:36
  SPEAKER_01: But again, it's important to keep in mind that's only for stock issued after July 4th, 2025.
• 10:41
  SPEAKER_01: So if you hold stock that you that you purchased prior to July 4th, 2025, that it may still qualify for 1202, but it would just be under a different regime than if you purchased the stock after that date.
• 10:55
  SPEAKER_00: Okay.
• 10:55
  SPEAKER_00: Good to know.
• 10:57
  SPEAKER_00: Okay.
• 10:57
  SPEAKER_00: So on the surface, the rules can sound straightforward, but once you dig into the details, there are a lot of nuances that can create unexpected issues that you kind of insinuated earlier on that can get pretty complex.
• 11:10
  SPEAKER_00: So what are some of the most common traps or mistakes you see taxpayers make when trying to qualify for QSBS treatment?
• 11:18
  SPEAKER_01: Yes, unfortunately that is a big concern for businesses who are trying to, or investors who are trying to qualify their stock for Section 1202.
• 11:27
  SPEAKER_01: As I mentioned earlier, you want to make sure that you're you're taking a look at the requirements throughout the whole state growth of the company.
• 11:35
  SPEAKER_01: It's not just something that you have to look at initially.
• 11:37
  SPEAKER_01: And just make sure you're not, you know, tripping up any traps for the in-way area, as you mentioned.
• 11:42
  SPEAKER_00: Yeah.
• 11:42
  SPEAKER_01: Um, one big one is redemptions of stock redemptions.
• 11:46
  SPEAKER_01: There's some requirements around that the company cannot have redeemed a certain amount of stock close to the issuance of the stock that you're trying to qualify for, Section 1202.
• 11:57
  SPEAKER_01: So you just want to be very cognizant of any kind of restructuring that happens that might accidentally trip up, you know, that redemption rule.
• 12:07
  SPEAKER_01: Um also, you know, I kind of mentioned earlier that if your business is organized as a partnership and you may want to convert to a C corporation in order to qualify your stock for Section 1202, you just kind of want to make sure that you are doing that in a way that where you're not gonna accidentally trip up anything that's not gonna qualify you for 1202.
• 12:29
  SPEAKER_00: And these are really, really good tips.
• 12:30
  SPEAKER_00: A lot of people don't think about you're like, hey, I'm just switched over, but you have to think about how and what's happening in those moments and the dates.
• 12:37
  SPEAKER_00: And it's a lot.
• 12:38
  SPEAKER_01: Yeah, you want to make sure you're working with a tax advisor, especially if you're doing any kind of conversion to a to C corporation stock or anything along those lines, just to make sure that you're not accidentally, you know, tripping anything up there.
• 12:50
  SPEAKER_01: There's another requirement that I didn't mention earlier related to your business, it has to be in an active trader business.
• 12:56
  SPEAKER_01: So you can only have a certain percentage of your assets invested in things like you know, stock of other corporations or real estate or more passive type investments.
• 13:06
  SPEAKER_01: Um, so if you accidentally trip over one of those percentages, like say you have too much cash on hand or working capital on hand in the business at any given time during the time that you own the stock, that can accidentally trip up some kind of disqualification.
• 13:21
  SPEAKER_01: So you just um there's a lot.
• 13:23
  SPEAKER_01: And so it's just kind of important to check in with your tax advisor regularly and make sure you're kind of aware of the requirements and not accidentally tripping something up.
• 13:31
  SPEAKER_00: Got it.
• 13:32
  SPEAKER_00: Okay.
• 13:32
  SPEAKER_00: So a lot of founders are focused on scaling the business and may not realize that certain decisions made early on can impact future eligibility.
• 13:42
  SPEAKER_00: So are there certain transactions, restructuring events, or business decisions that founders should approach carefully because they couldn't unintentionally impact QSBS eligibility?
• 13:53
  SPEAKER_01: Yeah, I think kind of what we just talked about, just making sure you're not accidentally investing in too much passive type activity.
• 14:00
  SPEAKER_01: Anytime you have any kind of stock redemption restructuring, or like I mentioned earlier, if you are organized as a partnership and want to convert to a C corporation stock in order to qualify, make sure you do that in the correct way.
• 14:13
  SPEAKER_01: I think some of the changes from OBBBA also just want to be very careful about that because you may have, you know, some stock that qualifies under the old rules and some qual stock that qualifies under the new rules, and just making sure you're tracking that carefully, as well as not assuming that some kind of reorganization you do post OBBBA is gonna necessarily qualify you under the under the new rules.
• 14:39
  SPEAKER_01: So I think it's important, especially with any kind of transaction-related situation that you consult with a tax advisor and make sure you're meeting all the requirements.
• 14:48
  SPEAKER_00: Lauren, you're giving away all the good tips.
• 14:51
  SPEAKER_00: Trust your advisor.
• 14:53
  SPEAKER_00: Yes.
• 14:54
  SPEAKER_00: So investors are increasingly looking at tax efficiency alongside investment returns when evaluating opportunities.
• 15:02
  SPEAKER_00: From an investor perspective, how can Section 1202 influence investment strategy, deal structure, or exit planning?
• 15:10
  SPEAKER_01: Yeah, I think um it's just a matter of it's session 1202, and again, you know, just to emphasize, it's a really powerful tax planning tool.
• 15:18
  SPEAKER_01: So if you're looking at forming a business or starting a business or you're in the early stage of growth of a startup, you know, just making sure that you're aware of the benefits that you've kind of mapped out how these benefits, how much these benefits could it potentially impact you so that you're making the right decisions?
• 15:36
  SPEAKER_01: You know, there may be reasons why you'll decide, okay, Section 1202 is not for me because I want to do this with my business and it's just not gonna work out for me.
• 15:44
  SPEAKER_01: But just making sure you understand and you've mapped that out and done your modeling to make sure, okay, is the benefit of Section 1202 down the line when I sell this stock worth, you know, me making some changes in how I'm going to, you know, organize or run my business over the next three, five years, whatever the case may be, just to make sure you're kind of aware, okay, I might need to make some business decisions, you know, just based on the potential benefit of 1202.
• 16:14
  SPEAKER_00: Thank you.
• 16:15
  SPEAKER_00: Okay.
• 16:15
  SPEAKER_00: There's also a growing need for advisors, attorneys, and tax professionals to work together much earlier in the life cycle of these companies.
• 16:24
  SPEAKER_00: So, why is proactive coordination between founders, investors, and advisors so important when it comes to preserving QSBS benefits?
• 16:34
  SPEAKER_01: Yeah, I mean, I think we've talked about it quite a bit.
• 16:36
  SPEAKER_01: You know, it's just like it's it's that initial decision when you're forming the business or you're buying the stock.
• 16:42
  SPEAKER_01: One requirement I also didn't mention earlier of 1202 is that you have to purchase the stock from the company itself.
• 16:50
  SPEAKER_01: Okay.
• 16:50
  SPEAKER_01: Um, so you can't purchase it from another shareholder.
• 16:53
  SPEAKER_01: So when you're initially investing in this company and buying the stock from the corporation, um just understanding, you know, 1202 even at that stage and consulting with your tax advisors at that stage, okay, what do I need to do to make sure that I can take advantage of this benefit all the way through the life cycle of the business, just making sure that the business is structured in a way and is making decisions in a way that it may, you know, ensures that the business continues to qualify for Section 1202.
• 17:20
  SPEAKER_01: Um, and I think it's just um the requirements are so complex that it is just a discussion that you probably want to make with your tax advisor.
• 17:29
  SPEAKER_01: It's not allowed for and then in the end, when you're close to an exit and you're you're thinking, oh wow, well, I wasn't aware of this, but maybe I should have been, and what should I be looking at now?
• 17:39
  SPEAKER_01: You're consulting with a tax advisor then and saying, does my stock qualify?
• 17:44
  SPEAKER_01: Like I wasn't aware of this initially, so I haven't actually organized everything in a way that does qualify.
• 17:49
  SPEAKER_01: But can you go back and take a look and see, you know, if there there is that chance that we could qualify, or are there a few changes we could make now or hold the stock a little bit longer that will allow us to qualify?
• 18:01
  SPEAKER_00: Okay.
• 18:02
  SPEAKER_00: For founders and investors listening who may not know whether they currently qualify or who haven't reviewed their structure in years, this conversation can probably feel quite overwhelming.
• 18:13
  SPEAKER_00: Um, what would your advice be for businesses and investors, investors, excuse me, that want to evaluate their QSBS eligibility and make sure they're positioning correctly before future transsaction or exit event?
• 18:27
  SPEAKER_01: Yeah, like I mentioned, I mean, just because I think this is our last, you know, discussion point, just emphasizing that this can be a huge tax saving opportunity.
• 18:37
  SPEAKER_01: So if a business is, you know, kind of a business owner or founder or investor is you know late in the process and is looking at an exit in the near future, they definitely would want to consult with a tax advisor, kind of do a study for lack of a better term, a Section 1202 study to determine, okay, does my business qualify?
• 18:59
  SPEAKER_01: Is there any chance, even though I wasn't aware of this previously, or um, you know, maybe there's some things that I can do to restructure that will help my business qualify because it is such a powerful tax planning opportunity, and especially after the changes of the OBBBA.
• 19:16
  SPEAKER_01: So any any you know, founder or you know, early stage investor in a small business would definitely want to take a close look and just make sure that they meet the qualifications and and consult with you know their their advisors to determine just be because the requirements are can be so complex, just making sure there's nothing along the way that's tripped up that business and disqualified it from Section 1202.
• 19:41
  unknown: Okay.
• 19:42
  SPEAKER_00: Well, thank you, Lauren.
• 19:43
  SPEAKER_00: This was a great conversation.
• 19:44
  SPEAKER_00: I learned a lot for sure.
• 19:46
  SPEAKER_00: I'm sure our audience learned a lot as well.
• 19:48
  SPEAKER_00: And thank you so much, and I hope to see you back soon.
• 19:51
  SPEAKER_01: Thank you for having me.
• 19:52
  SPEAKER_00: Of course.
• 19:53
  SPEAKER_00: Thank you.
• 19:55
  SPEAKER_00: That wraps up today's conversation with Lauren Brown.
• 19:58
  SPEAKER_00: One of the biggest takeaways from today's conversation is this.
• 20:01
  SPEAKER_00: When it comes to Section 1202 and qualified small business stock, proactive planning and understanding the details can make a significant difference in long-term value and tax savings.
• 20:12
  SPEAKER_00: From eligibility requirements to structuring considerations and recent legislative changes, the decisions made today can have a lasting impact on future growth and exit opportunities.
• 20:24
  SPEAKER_00: Thanks for tuning in to Beyond the Ledger.
• 20:26
  SPEAKER_00: For more insights and expert perspectives, visit VTCPA.net and explore our latest resources.
• 20:33
  SPEAKER_00: And don't forget to like, follow, and subscribe so you don't miss future conversations.
• 20:39
  SPEAKER_00: Until next time, I'm Sardin Lakefield, and I'll see you on the next episode.