Key takeaways

  • If you’re a U.S. taxpayer, you typically have to pay U.S. federal capital gains taxes whenever you sell stock held in a company for gain.
  • Depending on how long you’ve held the shares at the time of sale, if you sell your shares at a gain you’ll generally owe either short-term or long-term capital gains taxes, both of which have rates that vary according to your taxable income.
  • Selling qualified small business stock (QSBS) may exempt you from paying U.S. federal long-term capital gains taxes on the sale of the shares, but several specific requirements for sellers and the stock must be met to qualify for the tax exemption.
  • If you’re unsure of whether any stock of a new company you’re holding meets the QSBS requirements – or if you’re eligible for certain tax exemptions – consult a tax professional.

Contributors

Megan Werner

Content Marketing Strategy Associate, J.P. Morgan Wealth Management

When a company’s shareholders sell their stock at a gain, they typically have to pay taxes on the sold shares, which are known as capital gains taxes. Depending on how long you’ve held these shares at the time of sale you’ll pay either short-term or long-term capital gains taxes, and the applicable rate will depend on your overall taxable income. For example, if you hold the shares for over a year and then sell them, the current top U.S. federal long-term capital gains tax would be approximately 20%.1

While it’s nearly impossible for the average taxpayer to predict how tax laws may change in the future, you should review and understand existing tax regulations to optimize tax efficiencies and avoid any potential future penalties.

Tax rate hikes: Certain exemptions may become more valuable

Generally speaking, tax deductions or exemptions become more valuable as tax rates rise. If tax rates on federal long-term capital gains do increase in the future, one particular exemption that could become even more valuable is a long-term capital gains tax exemption for certain gains from the sale of qualified small business stock (QSBS) under Section 1202 of the Tax Code (i.e., the 1202 exemption).2

Investors and potential new small business owners should carefully consider the QSBS rules that might apply to starting a new business, including whether stock issued by a new company could qualify as QSBS and if a future sale of the stock by such shareholder could qualify for the Section 1202 exemption.3 But under current law, in order for stock of a new company to qualify as QSBS stock – and potentially be eligible for the 1202 exemption at a later date (among other complex requirements that are applicable during the holding period) – it must meet the following stipulations:

  • The new company must be a U.S. C corporation (an entity in which the owners and/or shareholders are taxed separately from the company itself)4
  • The stock must be acquired by the stockholder directly from the company in a primary issuance, generally in exchange for cash or services5
  • The company’s aggregate gross assets (i.e., the amount of cash and the aggregate adjusted basis of assets) must not exceed $50 million at any time before, up until and immediately after the shareholder acquires the stock (including cash the shareholder uses to buy the shares)6
  • The company must meet an active business test by utilizing at least 80% of its assets (by value) in a qualified trade or business (explained more below)7
  • The shareholder must be a qualified shareholder (explained more below)8
  • The shareholder must hold the shares for at least five years before selling them9

There are, however, important details worth noting about these requirements. To meet the first requirement, the stock cannot be stock of either a non-U.S. corporation or an S corporation (i.e., a flow-through entity through which the owners and/or shareholders are subject to U.S. federal income tax).10 For the second requirement, the shareholder is not allowed to have acquired the stock from a third party in a secondary sale, but must have received it directly from the issuing company itself. As for a company’s gross assets, this generally includes all assets of any company subsidiary that is at least 50% owned by the parent company, aggregating any subsidiary assets with the majority-holding parent company’s assets.

QSBS: Who qualifies and who doesn’t

For a shareholder to be a qualified shareholder, they cannot be a C corporation themselves, meaning they must be an individual.11 Similarly, only certain types of businesses count as a qualified business for the purpose of QSBS, while several types of businesses cannot.12 Business types that generally don’t meet the definition of qualified businesses include the following:

  • Law
  • Accounting
  • Financial services
  • Health care
  • Engineering
  • Consulting
  • Athletics
  • Performing arts
  • Banking
  • Insurance
  • Financing
  • Leasing
  • Investing
  • Farming
  • Hospitality (i.e., operating a hotel, motel or restaurant)

If your new company meets these QSBS requirements – and the Section 1202 exemption applies to the sale of the company’s shares by a qualified shareholder – under current law, the maximum amount of gain that can generally be exempt under the Section 1202 exemption is the greater of $10 million (reduced by eligible gain taken in previous years) or 10 times the shareholder’s aggregate adjusted tax basis in the QSBS sold during the year.13

Considerations for business owners who want to prime their company for a QSBS exemption

If you’re forming a new company and are looking to qualify for the Section 1202 exemption, it’s wise to consult with a tax professional who can advise on carefully navigating the complex requirements for shares of a new C corporation to qualify as QSBS. Nevertheless, there are some things you can do to prime your new company to potentially qualify for these exemptions.

First, your company must be formed as a C corporation (or as a Limited Liability Company [LLC] that duly and timely files an election to be classified as a corporation for U.S. federal income tax purposes). As we mentioned earlier, certain types of business can’t qualify for the Section 1202 exemption, so the type of business you establish is key. Keep in mind, too, that it’s important to test whether your company is still meeting these requirements after it issues new shares, is maintaining them throughout the shareholder’s holding period and is meeting them at the time of the subsequent disposition of the shares. For example – and assuming all the requirements have been met – newly issued shares of a corporation may qualify as QSBS if the gross asset basis test is met immediately after the shares are issued (e.g., if new shares are issued when the company has an aggregate gross asset basis of $40 million).14

However, if the aggregate gross assets of the company increases over time, a subsequent block of additional shares that are issued in your company later on may not pass the gross asset test, even if the other QSBS requirements are still being met and the previously issued shares still qualify as QSBS. To illustrate, this can happen if a company’s additional block of shares is issued at a time when the aggregate gross asset basis is $75 million; in this case, these additional shares will not qualify as QSBS, even if previously issued shares in the same company did.

What’s more, several of the requirements must be monitored and maintained over the course of the shareholder’s holding period. For example, the corporation must meet the active business test for substantially all of the shareholder’s holding period for its shares.15 Consult a tax professional if you have any questions related to the above.

Considerations for investors investing in QSBS

To review, below are a couple of things to keep in mind when determining if a company you’d like to invest in meets the QSBS exemption requirements:

Document your purchase. Keep track of each stock purchase in your portfolio, including the date you bought the stock and the amount you paid for it. Keep a copy of the cashed check or wire, along with an account statement showing the funds leaving your account. Don’t forget to save a copy of the share certificate, either.

Have your stock certified. If you think you’re investing in a company that may qualify for the QSBS exemption, confirm with the company that they adhere to the following stipulations:

  • The company is a domestic C corporation
  • The corporation’s aggregate gross assets never exceeded $50 million at any time from August 10, 1993, until immediately after the issuance of your stock
  • At least 80% of the company assets are being used in the active conduct of a qualifying trade or business

As you can see, qualification for QSBS and the Section 1202 exemption is highly complex, and you should consult a tax advisor if you’re interested in learning more.

The bottom line

While this primer may not describe all the necessary requirements for company stock to qualify as QSBS (or the Section 1202 exemption), understanding the basics is an important first step to potentially harnessing it into your tax investment strategy. If you’re curious whether any stock you own qualifies as QSBS – or if you may qualify for any of the exemptions mentioned above – consult a tax professional to learn more. It’s important to note that not all states conform to federal QSBS treatment, so you should discuss with a tax professional the potential state tax implications.

References

1.

Internal Revenue Service (IRS), “Topic no. 409, Capital gains and losses.” (January 30, 2024)

2.

I.R.C. Section 1202(a).

3.

Ibid.

4.

I.R.C. Section 1202(c)-(d).

5.

Ibid.

6.

I.R.C. Section 1202(e).

7.

I.R.C. Section 1202(e).

8.

I.R.C. Section 1202(a)(1).

9.

I.R.C. Section 1202(b)(2).

10.

I.R.C. Section 1202(c).

11.

I.R.C. Section 1202(a).

12.

I.R.C. Section 1202(e)(3).

13.

I.R.C. Section 1202(b).

14.

I.R.C. Section 1202(e).

15.

I.R.C. Section 1202(c).

Connect with a Wealth Advisor

Our Wealth Advisors begin by getting to know you personally. To get started, tell us about your needs and we’ll reach out to you.

Connect now

IMPORTANT INFORMATION

This material is for informational purposes only, and may inform you of certain products and services offered by J.P. Morgan’s wealth management businesses, part of JPMorgan Chase & Co. (“JPM”). Products and services described, as well as associated fees, charges and interest rates, are subject to change in accordance with the applicable account agreements and may differ among geographic locations. Not all products and services are offered at all locations. If you are a person with a disability and need additional support accessing this material, please contact your J.P. Morgan team or email us at accessibility.support@jpmorgan.com for assistance. Please read all Important Information.


GENERAL RISKS & CONSIDERATIONS
Any views, strategies or products discussed in this material may not be appropriate for all individuals and are subject to risks. Investors may get back less than they invested, and past performance is not a reliable indicator of future results. Asset allocation/diversification does not guarantee a profit or protect against loss. Nothing in this material should be relied upon in isolation for the purpose of making an investment decision. You are urged to consider carefully whether the services, products, asset classes (e.g. equities, fixed income, alternative investments, commodities, etc.) or strategies discussed are suitable to your needs. You must also consider the objectives, risks, charges, and expenses associated with an investment service, product or strategy prior to making an investment decision. For this and more complete information, including discussion of your goals/situation, contact your J.P. Morgan representative.

NON-RELIANCECertain information contained in this material is believed to be reliable; however, JPM does not represent or warrant its accuracy, reliability or completeness, or accept any liability for any loss or damage (whether direct or indirect) arising out of the use of all or any part of this material. No representation or warranty should be made with regard to any computations, graphs, tables, diagrams or commentary in this material, which are provided for illustration/reference purposes only. The views, opinions, estimates and strategies expressed in this material constitute our judgment based on current market conditions and are subject to change without notice. JPM assumes no duty to update any information in this material in the event that such information changes. Views, opinions, estimates and strategies expressed herein may differ from those expressed by other areas of JPM, views expressed for other purposes or in other contexts, and this material should not be regarded as a research report. Any projected results and risks are based solely on hypothetical examples cited, and actual results and risks will vary depending on specific circumstances. Forward-looking statements should not be considered as guarantees or predictions of future events.

Nothing in this document shall be construed as giving rise to any duty of care owed to, or advisory relationship with, you or any third party. Nothing in this document shall be regarded as an offer, solicitation, recommendation or advice (whether financial, accounting, legal, tax or other) given by J.P. Morgan and/or its officers or employees, irrespective of whether or not such communication was given at your request. J.P. Morgan and its affiliates and employees do not provide tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any financial transactions.

Legal Entity and Regulatory Information.

J.P. Morgan Wealth Management is a business of JPMorgan Chase & Co., which offers investment products and services through J.P. Morgan Securities LLC (JPMS), a registered broker-dealer and investment adviser, member FINRA and SIPC. Insurance products are made available through Chase Insurance Agency, Inc. (CIA), a licensed insurance agency, doing business as Chase Insurance Agency Services, Inc. in Florida. Certain custody and other services are provided by JPMorgan Chase Bank, N.A. (JPMCB). JPMS, CIA and JPMCB are affiliated companies under the common control of JPMorgan Chase & Co. Products not available in all states.

Bank deposit accounts and related services, such as checking, savings and bank lending, are offered by JPMorgan Chase Bank, N.A. Member FDIC.

This document may provide information about the brokerage and investment advisory services provided by J.P. Morgan Securities LLC (“JPMS”). The agreements entered into with JPMS, and corresponding disclosures provided with respect to the different products and services provided by JPMS (including our Form ADV disclosure brochure, if and when applicable), contain important information about the capacity in which we will be acting. You should read them all carefully. We encourage clients to speak to their JPMS representative regarding the nature of the products and services and to ask any questions they may have about the difference between brokerage and investment advisory services, including the obligation to disclose conflicts of interests and to act in the best interests of our clients.

J.P. Morgan may hold a position for itself or our other clients which may not be consistent with the information, opinions, estimates, investment strategies or views expressed in this document.  JPMorgan Chase & Co. or its affiliates may hold a position or act as market maker in the financial instruments of any issuer discussed herein or act as an underwriter, placement agent, advisor or lender to such issuer.