DEFINITION of 'QSBS (Qualified Small Business Stock)'

A qualified small business stock (QSBS) is simply the stock or share of a qualified small business (QSB). A qualified small business is defined as a domestic and active C-corporation whose gross assets (valued at original cost) do not exceed $50 million as of the date the stock was issued and immediately after issuance.

Section 1202 of the Internal Revenue Code (IRC) defines a qualified business as one that does not operate in the hospitality industry, financial sector, farming business, and any business that is heavily dependent on the skill of one or more of its employees such as health, law, accounting, engineering, consulting, architecture, etc. Businesses that qualify include companies in the technology, retail, wholesale, and manufacturing fields.

BREAKING DOWN 'QSBS (Qualified Small Business Stock)'

A qualified small business stock (QSBS) is specifically any stock that was acquired from a qualified small business after August 10, 1993. In order for the investor to claim the stock as qualified for tax purposes, s/he must have acquired the stock at its original issue (not the secondary market) with cash or property or as payment for a service. Also, it’s not enough to just purchase or acquire the stock; the investor has to have held the stock for at least five years to reap the tax benefits of a QSBS.

The tax treatment for a QSB stockholder is dependent on when the stock was acquired and how long it was held for. In December 2015, the Protecting Americans from Tax Hikes Act (PATH Act) was passed by Congress to allow QSB investors to exclude 100% of capital gains on small business stock as long as the stock qualifies under Section 1202 of the IRC.

  • QSBS acquired after Sept. 27, 2010: 100% exclusion on capital gain applies, which also includes an exclusion from the alternative minimum tax (AMT) and net investment income (NII) tax. AMT is normally imposed on individuals or investors who have tax exemptions that allow them to decrease the income tax due.
  • QSBS acquired between Feb. 18, 2009 and Sept. 27, 2010: 75% exclusion on capital gain applies. 7% of the gain is also subject to AMT.
  • QSBS acquired between Aug. 11, 1993 and Feb. 17, 2009: 50% exclusion is applied to capital gains, and 7% of the capital gains is subject to AMT.

Note that in any event, the exclusion has a cap – $10 million or 10 times the adjusted basis of the stock, whichever is greater. For example, if you invested $1.5 million in a tech startup on October 1, 2010 and held it for five years, you can sell the QSBS for up to (10 x $1.5 million) + $1.5 million = $16.5 million, and pay zero federal tax on the $15 million capital gain. This is, 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 his capital gain of $10 million.

Also important to note is that the amount of gains from a sale proceed that is not excluded is subject to a 28% capital gains tax. In the case of the first investor above, if his total proceeds from the sale totaled up to $20 million, a 28% capital gains tax will be applied to $20 million - $15 million = $5 million gain.

If the stockholder wants to sell his stock but hasn’t held it for the minimum holding period of five years, which would qualify the stock for capital gains exclusion, he can defer the gain by reinvesting the proceeds from the sale in another QSBS in another company within 60 days of the sale. Section 1045 of the IRC allows for this provision whereby an investor can rollover earnings made from the sale of a QSBS held for at least 6 months into a different QSBS, thereby, also rolling over the holding period and cost basis. This mechanics, in effect, defers the tax due on any capital gain made on the original QSBS.

Qualified startups and qualified businesses looking to expand their operations may raise initial or additional capital through QSBS. These companies can also use QSBS in the form of an in-kind payment to compensate employees for services rendered when cash flow is minimal. QSBS can also be used to retain employees in a qualified business to give them an extra incentive to help the company grow and succeed.

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