Qualified Small Business Stock (QSBS) Explained
Qualified small business stock (QSBS) are qualified small business (QSB) shares that meet certain IRS guidelines. Those who own QSBS may be eligible to exclude some or all gains when realizing a gain from sale.
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What Is QSBS?
QSBS, or qualified small business stock, are shares of a qualified small business. To qualify, the small business must have a value of $50 million or less in assets. When QSBS sales meet the rules set forth by IRS Section 1202, they may be eligible for exclusion from capital gains tax.
For the sale to be eligible, the company must be a U.S. company with assets of $50 million or less. The company cannot be on the excluded business type list, which includes professional sports organizations, law firms, healthcare companies, and financial services. The owner must have held the stock for at least five years before sale.
Tip: To be eligible for QSBS excluded sales, the shareholder must own stock, not options or other types of securities such as warrants.
Section 1202 QSBS Tax Exemption
The rules of QSBS are defined by IRS Code Section 1202. This section is also referred to as the Small Business Stock Gains Exclusion and was last amended on September 27, 2010. The code says that those who own stock in eligible companies that have $50 million in assets or less can exclude gains from federal tax. There is a limit to the amount of gain; the most that can be excluded is $10 million or 10 times the adjusted basis of the stock. As mentioned earlier, shareholders must hold the stock for at least five years to get the exclusion.
Tip: If shareholders sell the stock prior to the five-year period, they may invest in another company’s QSBS to defer gains as long as the rollover is done within a 60-day period from the date of the sale.
Other Benefits for Businesses
Businesses may elect to offer QSBS stock to employees to:
- Offer an incentive in helping build a startup business
- Create a favorable stock structure for employees
- Grow the company by attracting top-level talent
- Raise capital through the offering
QSBS Qualification Requirements
Investors will not get the tax benefits if their QSBS does not meet the qualification requirements. That means that ineligible stock sales would be taxed at the capital gains rate. In order to meet the QSBS qualifications:
- The company must get a 409A valuation of $50 million or less. The 409A valuation is an independent appraisal of a company’s assets.
- The equity must be a stock. Stock options, warrants, and convertible assets do not qualify.
- Must be held for at least five years.
Stocks acquired in 2010 and after are eligible for up to 100% tax exclusions. These qualifications must be retained throughout the holding period.
QSBS Tax Treatment Rules
The Section 1202 tax exclusion has not always been up to 100%. There have been several amendments to the tax code that have updated the amount to be excluded.
QSBS percentage of capital gains exclusions:
- 100%: If the qualified status is after September 27, 2010, the shareholder shall not include 100% of any gain.
- 75%: Qualified gains for eligible stock owned between February 18, 2009, and September 27, 2010, owners shall not include 75% of the gain.
- 50%: For those with qualified stock owned before February 18, 2009, they shall not include 50% of any gain.
QSBS Holding Period Rule
The QSBS Holding Period Rule states that shareholders must own the stock for a minimum of five years in order to be eligible for the Section 1202 gains exclusion.
QSBS Taxation Example
Assume that an investor makes $500,000 in ordinary taxable income, putting them in the highest capital gains tax bracket of 20%. If they acquired the qualified small business stock on November 1, 2016, and sold it on December 1, 2021, for $30,000 profit, they could exclude all gains from the sale on their tax return.
If they sold it on October 1, 2021, they would not meet the five-year rule and must either roll it over or pay the capital gains tax which would be 20% of the $30,000 or $6,000 in capital gains.
Benefits & Downsides of Buying QSBS
Investors should consider the pros and cons of investing in qualified small business stock. Because there are so many rules and risks, these investments aren’t for everyone but can be very profitable with the right companies.
Benefits of Buying QSBS for Investors
- Opportunity to invest in the company they are helping to build
- Tax benefit of excluding some or all of the capital gains on sales of the stock
- Meets an aggressive long-term stockholder investment strategy
Downsides of Investing in QSBS for Investors
- Requires a minimum of five years of investment in most cases
- Investments in non-proven young start-up companies can be risky
- The potential of not following the tax rules could result in capital gains taxes and penalties
Bottom Line
Investors can greatly benefit from owning qualified small business stock because they can sell it down the road and be exempt from most, if not all, of the capital gains taxes. Investors should consult with their investment and tax advisors to make sure that the QSBS fits into their investment plans and tax strategies.
This article was written by
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