What Is Qualified Small-Business Stock (QSBS)?

If you’re a startup founder trying to get a small business off the ground, we don’t need to tell you about the challenges of turning an idea into a success. We don’t need to tell you that more than two thirds of startups never deliver a positive return to investors, or that those that do depend on an alchemical mix of persistence, fortune, and an appetite for taking risks. The good news is that the IRS recognizes this too, and has created something called the qualified small-business tax exclusion to decrease the financial risk of holding shares in a startup or small business. 

Qualified small-business stock, or QSBS for short, is intended to promote investment in startups and small businesses by means of providing a truly incredible tax benefit to qualified shareholders. If you own shares in a small business and qualify for this tax exemption, you may be able to pocket any capital gains from your investment without paying a cent in capital gains tax. 

In this guide, we’ll further define QSBS and review how it works. As a founder, you (as well as the company issuing shares) will have to meet certain criteria in order to qualify for this tax exemption, but the potential tax benefits are impressive, to say the least.  

• What is qualified small-business stock (QSBS)?
• How does the QSBS exemption work?
• Which states conform with the QSBS tax exemption?
• Next steps for founders and shareholders

What is qualified small-business stock (QSBS)?

If you’ve heard of qualified small-business stock before reading this guide, you might also know it by the name of Section 1202 stock. This is because the QSBS tax exclusion is laid out in Section 1202 of the U.S. Internal Revenue Code (IRC), which outlines how certain small-business stocks can qualify for up to a 100% exclusion of tax on capital gains.

The history of QSBS dates back to the Revenue Reconciliation Act of 1993, which provided for a partial exclusion of capital gains tax for certain qualified small-business stock. This partial exclusion was expanded to a 100% exclusion for eligible stock as part of the Creating Small Business Jobs Act of 2010. 

As the name of that piece of legislation implies, QSBS was created as a means of fueling continued investment in small businesses. This makes sense! If an investor is weighing the risks of purchasing shares in a startup that has a good chance of going belly-up, she might be swayed toward investing if she knows that she can qualify for substantial tax savings on any profit. 

But the QSBS tax exemption doesn’t exist solely to entice outside investors. It can also incentivize founders and other internal stockholders to continue to invest within their own companies—and thus, presumably, to spur ever more growth. Knowing that you can pocket up to 100% of the additional value you create by growing a business can be quite the motivator.

How does the QSBS exemption work?

How much of a tax break a shareholder will qualify for depends on a number of criteria. There are essentially two sets of requirements to keep in mind: those pertaining to the business, and those pertaining to the shareholder. 

Here are the major QSBS rules to be aware of for each.

Which companies meet the requirements for a qualified small business?

Not to quibble over semantics, but it’s called qualified small-business stock because it only applies to qualified small businesses. So, what does that actually mean? Here are the criteria for qualified small-business stock, as outlined in Section 1202 of the IRC:

• The stock must be issued by a domestic C corporation. In other words, the company must be a C corporation based within the U.S.—importantly, this must be true as of the date the stock is issued.
• The corporation must have aggregate gross assets that do not exceed $50 million. This must be true both before and immediately after the issuance of the equity to the shareholder. It’s worth noting here that a company can have its QSBS status taken away even if it has qualified previously if, for example, its 409A valuation changes.
• The corporation must be actively engaged in business. With certain exceptions that apply to small business investment companies, the corporation in question must meet  the active business requirements outlined in Subsection (e) of Section 1202. For example, at least 80% of the company’s assets must be used in the active conduct of one or more qualified trades or businesses. Speaking of which…
• The corporation must be engaged in a qualified trade or business. Companies in certain trades and industries don’t qualify. These include: banking, insurance, financing, leasing, investing, or similar trades; any farming or mining/extraction business; any business operating a hotel, motel, restaurant, or similar business; any personal service, i.e. a trade or business based on the personal skills or reputation of one or more employees.‍
• The stock must be issued directly to the taxpayer. In other words, the stock must be acquired by the taxpayer directly from the company or through an underwriter.

Who can claim the QSBS benefit?

Just because a company is a qualified small business doesn’t mean that the shareholder qualifies for QSBS tax treatment on their stocks. Founders, entrepreneurs, investors, and employees alike must meet the following qualification requirements: 

• You must be an individual or an eligible pass-thru entity. Basically, this means you can’t be a corporation yourself. Eligible pass-thru entities include S corporations, partnerships, regulated investment companies, and common trust funds.
• You must satisfy a five-year holding period. If you sell your eligible shares within five years of receiving them, you won’t qualify for the QSBS tax benefit and may be subject to the normal tax rate on the sale of those shares. One exception applies if you sold QSB stock that you held for more than six months; in this case, you can elect to postpone gains if you buy other QSB stock within a 60-day window beginning on the date of the sale.
• You can only exclude gains up to $10,000,000—or 10 times the aggregate adjusted cost basis. The exclusion is limited to whichever of those two figures is higher. (The adjusted cost basis of a stock is its original value, which is used to determine how much you profit when you sell it.)

Additionally, it matters when you acquired the stocks in question:

• If you acquired the stocks after the Creating Small Business Jobs Act was enacted on September 27, 2010, and held them for over five years, any gains are tax-free.
• If you acquired the stocks from February 18, 2009 to September 27, 2010, and held them for over five years, up to 75% of your profit qualifies for a capital gains exclusion. 7% of the taxable portion may be subject to alternative minimum tax (AMT).
• If you acquired the stocks prior to February 18, 2009, and held them for over five years, up to 50% of your profit qualifies for a capital gains exclusion. 7% of the taxable portion may be subject to AMT.

If you’re not sure whether you qualify for the QSBS exclusion, we recommend consulting a tax advisor. 

Which states conform with the QSBS tax exemption?

Section 1202 is part of the U.S. federal tax code, but not every state conforms to the federal tax code when it comes to the QSBS exemption. 

For a qualified small business located in a conforming state, the amount of gain that’s reduced by the QSBS exemption also applies to state taxes. But in a non-conforming state, there may be no reduction in capital-gains tax owed. Some states fall in the middle; these partially conforming states may adhere to certain parts of the federal tax code but deviate from others.

Non-conforming states

Currently, the list of states that don’t conform to Section 1202 includes:

• Alabama
• California
• Mississippi
• New Jersey
• Pennsylvania

Partially conforming states

The list of states that currently conform to part of Section 1202, but not all, includes:

• Massachusetts
• Hawaii

Next steps for founders and shareholders 

The specific requirements that govern which companies are qualified small businesses and which shareholders qualify for the QSBS tax exemption can be confusing, to say the least. And it’s worth noting that certain situations can make things even messier. A change in your company’s 409A valuation, for example, may result in your company being disqualified for QSBS status.

The good news is that Pulley is here to help. We produce audit-ready 409A valuations that save you valuable time and give you insight into which equity grants may qualify for the QSBS exemption. Schedule a call with one of our representatives to see how you can get a trusted report in just five days.