Tax-Favored QSBC for the COVID-19 Era and Beyond

The COVID-19 crisis has taken a toll on many small businesses. But some winners are expected to emerge from the wreckage. Unprecedented steps will be taken to guard against health risks from COVID-19 and whatever might come along next. The new normal will create new opportunities. Small businesses that can respond to those opportunities will survive and thrive.Here's why operating as a tax-favored qualified small business corporation (QSBC) can be a smart move for eligible small businesses.

Tax Basics

QSBCs are a special breed of the C corporation species. The difference between QSBCs and garden-variety C corporations is that QSBC stock is potentially eligible for:

• A 100% federal income tax gain exclusion break, and
• A tax-free gain rollover break.

The 100% gain exclusion break translates into a 0% federal income tax rate on capital gains from eligible sales of QSBC stock.

You also benefit from the flat 21% federal income tax rate that C corporations pay, thanks to the Tax Cuts and Jobs Act (TCJA).

The gain exclusion and gain rollover breaks are available to individual taxpayers who own QSBC stock. However, these breaks aren't available to QSBC shareholders that are themselves C corporations. Gains from sales of QSBC stock that individuals own indirectly through "pass-through" entities (partnerships, limited liability companies (LLCs), and S corporations) are eligible, because the gain exclusion and gain rollover breaks are effectively passed through to individual owners.

The current 100% gain exclusion deal was made permanent for sales of QSBC shares that are acquired after September 27, 2010. So, shares issued recently, semi-recently or after you read this can potentially be classified as tax-favored QSBC stock. However, several rules and restrictions apply. Notably, you must hold the stock for more than five years to claim the gain exclusion.

Assuming your business is eligible for QSBC status, the following types of businesses will first need to be incorporated:

• Sole proprietorships,
• Single-member LLCs treated as sole proprietorships for tax purposes,
• Partnerships, and
• Multi-member LLCs treated as partnerships for tax purposes.

Important: The act of incorporating a business shouldn't be taken lightly. Please talk with your legal and tax advisors before taking that step.

In general, QSBCs are treated the same as regular C corporations for all other legal and federal tax purposes. In other words, beyond the federal income tax gain exclusion and gain rollover breaks, the standard advantages and disadvantages of C corporation status apply equally to QSBCs.

Limitations on Excludable Gains

Congress imposed limits on the amount of gain that can be excluded from selling shares in a particular QSBC. For purposes of this article, we'll refer to the amount of gain that qualifies for the gain exclusion break as the "eligible gain." In any taxable year, a taxpayer's eligible gain is limited to the greater of:

• 10 times the taxpayer's basis in the QSBC stock that's sold, or
• $10 million reduced by the amount of eligible gain already taken into account in prior tax years for dispositions of stock issued by the same QSBC (or $5 million if the taxpayer uses married filing separate status).

In effect, the $10 million (or $5 million) eligible gain limitation is a lifetime limitation for stock in a particular QSBC.

For example, Jo is unmarried. In 2026, she sells QSBC stock that she acquired in 2020. The stock has basis of $2 million. Jo sells the stock for $24 million, resulting in a gain of $22 million. She has never before excluded any gain from selling shares in this QSBC. Her eligible gain is limited to the greater of:

• $20 million (10 × $2 million basis of the stock), or
• $10 million reduced by eligible gains taken into account in prior tax years (if any).

In this case, Jo's eligible gain limitation is $20 million, because that's the greater of the two limitations. The remaining $2 million of gain is taxed as a garden-variety long-term capital gain that's potentially subject to the 3.8% net investment income tax (NIIT) on top of the capital gains tax.

Here's another example: Mark is unmarried. In 2026, he sells QSBC stock that he acquired in 2020. The stock has basis of $500,000. Mark sells the stock for $14.5 million, resulting in a gain of $14 million. His eligible gain is limited to the greater of:

• $5 million (10 × $500,000 basis of the stock), or
• $10 million reduced by eligible gains taken into account in prior tax years (if any).

In this case, Mark's eligible gain limitation is $10 million, because that's the greater of the two limitations. The remaining $4 million of gain is taxed as a garden-variety long-term capital gain that's potentially subject to the 3.8% NIIT on top of the capital gains tax.

Gain Rollover Privilege

There's also a tax-free gain rollover privilege for eligible QSBC shares. This privilege applies to gains recognized by an individual taxpayer, if the taxpayer elects gain rollover treatment.

Under the rollover rule, the amount of gain recognized is limited to the excess of QSBC stock sales proceeds over the amount reinvested to purchase other QSBC shares (replacement stock) during a 60-day period beginning on the date of the original sale. The rolled-over gain reduces the basis of the replacement stock. QSBC stock must have been held for more than six months to take advantage of gain rollover provision.

If the replacement stock is still QSBC stock when it's sold, the gain exclusion break is available if the more-than-five-year holding period requirement is met. The holding period of the stock sold in the rollover transaction is added to the holding period of the replacement stock.

Important: The rollover provision allows a QSBC shareholder to sell shares on a tax-deferred basis without losing eligibility for the gain exclusion break when the replacement stock is eventually sold.

Right for Your Business?

You may think that conventional wisdom dictates that it's best to operate privately owned businesses as pass-through entities. But that may not be the optimal choice if your venture would meet the definition of a QSBC if it was incorporated. The QSBC alternative offers three major upsides: 1) the potential for the 100% gain exclusion break when you sell your shares, 2) a tax-free stock sale gain rollover privilege, and 3) a flat 21% corporate federal income tax rate. Your tax advisor can help you assess whether QSBC status is right for your business venture under the current tax rules.

Beware: This may be a limited time opportunity. Depending on the results of the November elections, today's tax rules — including those that allow favorable tax treatment for QSBCs — may change or be eliminated. Your tax advisor can help you stay atop the latest developments, including the soon-to-be-unveiled tax platforms for the Republican and Democratic parties.