Qualified Small Business Stock (QSBS)

Qualified Small Business Stock (QSBS) refers to shares in a small business that meets certain criteria defined under Section 1202 of the Internal Revenue Code, which was designed to incentivize investment in small enterprises in the United States.  QSBS is a type of stock that, if held for at least 5 years, can entitle the holder to significant tax advantages upon sale.  Key beneficiaries are usually founders, employees, and startup investors.  

Qualification Criteria for a Business to Issue QSBS

• Domestic C Corporation: The stock must be of a U.S. domestic C corporation—not an S corporation, LLC, or any other entity structure.

• Original Issue: The stock must be acquired at its original issue, either directly from the corporation or through an underwriter. This is often in exchange for money or property or as compensation.

• $50 Million Gross Assets Test: The aggregate gross assets of the corporation must not have exceeded $50 million at any time before or immediately after the issuance of the stock. This includes the amounts received for the stock.

• Active Business Requirement: At least 80% (by value) of the assets of the corporation must be used in a qualified business activity during substantially all of the taxpayer's holding period for the stock.  Some industries, such as banking, farming, mining, and hospitality, are excluded from the definition of a qualified trade or business.

Significant Tax Advantages

• Exclusion from Gain: If you hold your QSBS for more than 5 years, you can exclude from your federal tax liability:

  • 100% of the gain at sale if the QSBS was acquired after September 27, 2010.

  • 75% of the gain at sale if the QSBS was acquired between February 18, 2009, and September 27, 2010.

  • 50% of the gain if the QSBS was acquired before February 18, 2009.

• Cap on Gain Exclusion: The amount of gain eligible for the federal tax exclusion is limited to the greater of:

  • $10 million reduced by the amount of any QSBS gain previously excluded by the taxpayer from that same corporation; or

  • 10 times the taxpayer's adjusted basis in the stock sold during the year.

• Deferral of Capital Gains Tax: If you sell your QSBS before holding it for at least 5 years, you may be eligible to defer paying capital gains tax by reinvesting the proceeds into another company’s QSBS.

How to Take Advantage of QSBS

• Hold the Stock: Ensure you hold the QSBS for at least five years.

• Recordkeeping: Maintain good records of the stock's acquisition date, the nature of the business, and the assets of the corporation at the time of acquisition.  Key documents to maintain include stock certificates, stock purchase agreements, option grant agreements and exercise notices.  Employees should also request the following information from their employer:

  • A Certificate of Qualification that verifies that the company is a QSB.

  • A Statement of Qualified Business Activity that describes the company’s business activity.

• Sale of QSBS: Upon selling the QSBS after a five-year holding period, report the sale on your federal income tax return.

• Claim the Capital Gains Exclusion: On your tax return, exclude the applicable percentage (50%, 75%, or 100%) of your capital gain from taxation.

Conclusion

QSBS can be an immensely valuable provision in the tax code for founders, employees, and investors of early stage companies.  If you are considering a QSBS investment, we recommend you consult with a financial advisor and tax professional to ensure the investment aligns with your overall financial goals and that you are in compliance with the tax code.  If you would like help finding one, do not hesitate to reach out.  We are here to help you find a trusted financial advisor that is right for you.