What Is Qualified Small Business Stock (QSBS)?
The term qualified small business stock (QSBS) refers to shares of a qualified small business (QSB) as defined by the Internal Revenue Code (IRC). A qualified small business is an active domestic C corporation whose gross assets—valued at the original cost—do not exceed $50 million on and immediately after its stock issuance. Individuals are able to receive tax benefits if they hold QSBS as long as they meet certain criteria.
- Qualified small business stock refers to shares of a qualified small business as defined by the Internal Revenue Code.
- QSBS is treated favorably for capital gains purposes if both the investor and the company meet certain requirements.
- How much of a tax break the investor will receive depends on when they purchased the stock and how long they held it.
- Investors who sell their QSBS before the end of the required holding period can defer capital gains by investing the proceeds in another company's QSBS.
Understanding Qualified Small Business Stock (QSBS)
The federal government allows individuals to invest in small businesses under Section 1202 of the Internal Revenue Code. As noted above, a QSB is any active domestic C corporation whose assets don't go over $50 million on or after the issuance of stock. Only certain types of companies fall under the category of a qualified small business. Firms in the technology, retail, wholesale, and manufacturing sectors are eligible as QSBs, while those in the hospitality industry, personal services, the financial sector, farming, and mining are not.
A qualified small business stock is any stock acquired from a qualified small business after Aug. 10, 1993. Under Section 1202, the capital gains from qualified small businesses are exempt from federal taxes. To claim the tax benefits of the stock being qualified, the following must apply:
- The investor must not be a corporation.
- The investor must have acquired the stock at its original issue and not on the secondary market.
- The investor must have purchased the stock with cash or property, or accepted it as payment for a service.
- The investor must have held the stock for at least five years.
- 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 tax treatment for a QSB stock depends on when the stock was acquired and how long it was held. The Protecting Americans from Tax Hikes Act (PATH Act) of 2015 allows investors to exclude 100% of capital gains on qualified small business stock. The exclusion has a cap of $10 million, or 10 times the adjusted basis of the stock—whichever is greater. Gains above that amount are subject to a 28% capital gains tax.
Qualified small business stock can be eligible for a capital gains exclusion of up to 100%.
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 whose tax exemptions would otherwise allow them to pay disproportionately low taxes for someone at their income level. The net investment income tax is applied to the lower amount between an individual's net investment income or the modified adjusted gross income (MAGI) amount in excess of the predetermined limit. The following is a list of how exclusions apply:
- A 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.
- A 75% capital gains exclusion for QSBS acquired between Feb. 18, 2009, and Sept. 27, 2010. However, 7% of the gain is subject to AMT.
- A 50% capital gains exclusion for QSBS acquired between Aug. 11, 1993, and Feb. 17, 2009. However, 7% of the gain is subject to AMT.
If someone invested $1.5 million in a tech startup on Oct. 1, 2010, and held that investment for five years, they could sell their QSBS for up to $16.5 million (10 x their original investment of $1.5 million) + $1.5 million, without owing capital gains tax. Once they deduct their initial investment, they have a $15 million capital gain—none of which is taxable on their federal income tax.
Similarly, an investor who put $500,000 into the same tech startup would be able to sell their shares for up to $10.5 million ($10 million + $500,000), with no tax on their capital gain of $10 million. However, if the investor's proceeds from the sale totaled $20 million, a 28% capital gains tax would be applied to the additional $10 million gain.
If a stockholder wants to sell their stock but has not held it for the minimum five-year holding period, Section 1045 of the IRC allows them to defer the gain by reinvesting the proceeds from the sale of that qualified small business stock into another QSBS within 60 days. This defers the tax due on any capital gain made on the original QSBS.
Types of Qualified Small Business Stock (QSBS)
Qualified startups and qualified existing businesses that want to expand their operations may raise initial or additional capital through a QSBS offering. These companies may also use qualified small business stock as a form of in-kind payment. In-kind payments are frequently used to compensate employees for their services when cash flow is minimal. QSBS can also be used to retain employees and as an incentive to help the company grow and succeed.