What is a Qualified Small Business Stock (QSBS)
A qualified small business stock (QSBS) is the stock, or share, of a qualified small business (QSB), as defined by the Internal Revenue Code (IRC). A qualified small business is a domestic and active C-corporation whose gross assets, valued at original cost, do not exceed $50 million on and immediately after its stock issuance.
BREAKING DOWN Qualified Small Business Stock (QSBS)
A qualified small business stock (QSBS) is any stock acquired from a qualified small business (QSB) after August 10, 1993. To claim the tax benefits of a share being qualified, the following must apply:
- The investor must not be a corporation
- Must have acquired the stock at its original issue and not from the secondary market
- Purchase the stock with cash or property, or as payment for a service
- The investor must hold the stock for at least five years to reap the tax benefits of a QSBS.
- At least 80% of the issuing corporation's assets must be used in the operations of one or more of its qualified trades or businesses.
The Internal Revenue Code (IRC) Section 1202 defines a qualified small business (QSB). These QSBs do not operate in the hospitality industry, financial sector, farming business, or any business heavily dependent on the skill of one or more of its employees such as healthcare, law, accounting, engineering, consulting, architecture, and others. Businesses that qualify for QSB status include companies in the technology, retail, wholesale, and manufacturing fields.
Qualified startups and qualified businesses looking to expand their operations may raise initial or additional capital through a QSBS offering. These companies may also use qualified small business stock (QSBS) as a form of an in-kind payment. In-kind payments are frequently utilized to compensate employees for services rendered when cash flow is minimal. QSBS can also be used to retain employees and as an incentive to help the company grow and succeed.
Tax Implications for Qualified Small Business Stocks
Tax treatment for a QSB stock depends on when the stock was acquired and the length of its holding. The Protecting Americans from Tax Hikes Act (PATH Act), allows investors to exclude 100% of capital gains on qualified small business stock (QSBS) if the stock qualifies under Section 1202 of the IRC. The exclusion has a cap of $10 million, or 10 times the adjusted basis of the stock, whichever is greater. Gains from non-excluded sales proceeds are subject to a 28% capital gains tax.
Additionally, there are holding requirements for the full exclusion of alternative minimum tax (AMT) and net investment income (NII) tax. The AMT is typically imposed on individuals or investors who have tax exemptions that allow them to decrease their income tax due.
- 100% capital gains exclusion for QSBS acquired after Sept. 27, 2010. A 100% exclusion on capital gain applies, which also includes exclusions from the AMT and NII tax.
- 75% capital gains exclusion for QSBS acquired between Feb. 18, 2009, and Sept. 27, 2010. However, 7% of the gain is subject to AMT.
- 50% capital gains exclusion for QSBS acquired between Aug. 11, 1993, and Feb. 17, 2009. However, 7% of the gain is subject to AMT.
Example of QSBS Capital Gains Taxation
For example, if you invested $1.5 million in a tech startup on October 1, 2010, and held that investment for five years, you can sell the QSBS for up to (10 x $1.5 million, which was the original investment) + $1.5 million = $16.5 million. Once you deduct your initial investment, you have a $15 million capital gain. You will pay zero federal tax on the $15 million capital gain. This case applies, of course, if the startup appreciates in value. Likewise, an investor who seeded $500,000 in the same tech startup will be able to sell up to $10 million + $500,000 = $10.5 million without tax being applied to the capital gain of $10 million.
In the case of the investor above, if his total proceeds from the sale totaled $20 million, a 28% capital gains tax would be applied to the $5 million gain ($20 million - $15 million).
If the stockholder wants to sell his stock but has not held it for the minimum 5-year holding period, Section 1045 of the IRC allows him to defer the gain by reinvesting the proceeds from the sale of the qualified small business stock (QSBS) into another QSBS within 60 days. This defers the tax due on any capital gain made on the original QSBS.