7521 / What is qualified small business stock?

An issuing corporation is a qualified small business if it is a domestic corporation with aggregate gross assets of $50,000,000 or less at all times after August 10, 1993. Generally, “aggregate gross assets” means the amount of cash and the aggregate adjusted bases of other property held by the corporation. Under certain circumstances, a parent corporation and its subsidiary corporations may be treated as one corporation for purposes of determining a corporation’s aggregate gross assets.²

As a general rule, stock acquired by the taxpayer will not be treated as “qualified small business stock” if the issuing corporation has directly or indirectly purchased any of its stock from the taxpayer (or a related person) within two years before or after the date of issuance.³ But an issuing corporation may redeem de minimis amounts of stock without the loss of qualified small business stock treatment. Stock redeemed from a taxpayer (or related person) exceeds a de minimis amount of stock only if the aggregate amount paid for the stock exceeds $10,000 and more than 2 percent of the stock held by the taxpayer and related persons is acquired.⁴

Similarly, stock issued by a corporation will generally not be treated as qualified small business stock if the issuing corporation makes a significant redemption of stock or, in other words, redeems stock with an aggregate value of more than 5 percent of the value of all of its stock within one year before or after the date of issuance.⁵ But an issuing corporation may redeem de minimis amounts of stock without the loss of qualified small business stock treatment. Stock redeemed by an issuing corporation exceeds a de minimis amount only if the aggregate amount paid exceeds $10,000 and more than 2 percent of all outstanding stock is purchased.⁶

In addition, the following stock redemptions are disregarded in determining whether redemptions exceed de minimis amounts and will not result in the loss of qualified small business stock treatment: (1) a redemption of stock acquired in connection with the performance of services as an employee or director (or an option to acquire such stock) incident to the seller’s retirement or other bona fide termination of such services; (2) a purchase from a deceased shareholder’s estate, beneficiary, heir, surviving joint tenant, surviving spouse, or a trust established by the decedent or decedent’s spouse, and the purchase is within three years and nine months of the decedent’s death, provided that prior to the decedent’s death, the stock (or an option to acquire the stock) was held by the decedent or decedent’s spouse (or by both), by the decedent and joint tenant, or by a trust revocable by the decedent or decedent’s spouse (or by both); (3) a purchase incident to the disability or mental incompetence of the selling shareholder; or (4) a purchase incident to the divorce (within the meaning of IRC Section 1041(c)) of the selling shareholder (see Q 789). Also, transfers by shareholders to an employee or independent contractor (or beneficiary thereof) in connection with the performance of services are generally not treated as redemptions.⁷

Stock acquired through the conversion of qualified small business stock of the same corporation will be considered qualified small business stock held for the same period that the converted stock was held by the taxpayer.⁸

In order to satisfy the active business requirement, at least 80 percent of the issuing corporation’s assets must be committed to the active conduct of one or more “qualified trades or businesses,” and the corporation must be an “eligible corporation.”⁹ (A specialized small business investment company is not subject to this requirement,¹⁰ see Q 7520.) A “qualified trade or business” is a trade or business other than one that involves (a) the performance of services in a field where the principal asset of the trade or business is the reputation or skill of one or more employees, such as the fields of law, accounting, performing arts, or athletics; (b) any insurance, banking, financing, leasing, investing, or similar business; (c) any farming business; (d) any mining business for which a percentage depletion deduction is allowed under the IRC; or (e) any business operating a hotel, motel, restaurant, or similar business.¹¹

Regardless of whether the active business requirement is met, stock will not be treated as qualified small business stock unless the issuing corporation is an eligible corporation. An “eligible corporation” is a domestic corporation other than (a) a domestic international sales corporation (“DISC”) or former DISC; (b) a regulated investment company (“RIC”), a real estate investment trust (“REIT”), or a real estate mortgage investment conduit (“REMIC”); (c) a cooperative; or (d) a corporation that has made an election under IRC Section 936 (relating to the U.S. possession tax credit).¹²