Qualified Small Business Stock (QSBS): Frequently Asked Questions

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QSBS status allows founders, investors, and employees to take advantage of favorable tax treatment when selling stock. However, for this to happen certain criteria have to be met by both the company issuing the stock and the individual selling it. Below is a general overview of QSBS and some ideas on how to take advantage of it.

QSBS refers to a type of stock that meets the criteria outlined in the Internal Revenue Code, Section 1202. This tax provision is designed to incentivize investment in small businesses by providing potential tax benefits to investors and stockholders (such as founders and employees).

In broad terms, to take advantage of the favorable tax treatment, conditions must be met by both the company issuing stock and the stockholder:

Company criteria overview

• The issuing company must be a domestic (US) C corporation
• Total gross assets should not exceed $50 million at the time of stock issuance (for startups, this usually boils down to having raised less than $50M at the time of issuance)
• Note that QSBS status is not tied to valuation. As long as a company has raised less than $50M in cash or other real property, the company’s valuation is irrelevant as far as QSBS status is concerned
• Active Business Requirement: The corporation must be engaged in an active business, and at least 80% of its assets must be used in the active conduct of that business

Stockholder criteria overview

• The stockholder must have obtained the security from the issuing company directly (eg. either by buying it from the company -as an investor-, or executing stock options granted by the company -founders/employees) as opposed to through a secondary transaction
• The stockholder must hold the stock for at least 5 years before being able to take advantage of the preferential tax treatment

FAQs

Can Pulley certify my company as QSBS eligible?

QSBS is simply a preferential tax treatment the IRS gives you, as opposed to a feature one can offer or anyone can certify. As long as a company and stockholder meet the appropriate requirements, a stockholder can take advantage of QSBS when filing taxes and reporting the proceeds of a qualifying sale.

Neither Pulley nor anyone else can "qualify" a company to be QSBS eligible. The most that anyone can do as far as "qualifying" you for QSBS is to give their professional opinion on whether they think you'd be eligible under existing IRS rules. It is ultimately up to the IRS to determine or contest anyone's opinion on the matter.

Do I need an attestation letter to be QSBS eligible?

No. One can take advantage of QSBS preferential tax treatment if both the issuing company and stockholder meet the IRS’s guidelines. Taking advantage of QSBS is simply a matter of reporting your income gains from the sale of stock as QSBS eligible when you file your taxes.

That being said, the IRS could audit someone trying to take advantage of QSBS, in which case all of the information and documentation needed to contest the audit exist within Pulley (i.e. dated share certificates and company fundraising milestones). We recommend talking to your accountant and tax professional before selling QSBS stock and when filing your taxes.

What happens if I’m audited by the IRS? How can Pulley help?

An IRS’s QSBS-related audit would most likely question the length of time for which a stockholder has held their QSBS stock before selling (one needs to hold stock for at least 5 years to take advantage of the preferential tax treatment). Pulley’s dated stock certificates are the first step to contest such an audit.

Additionally, when you file an 83(b) form you are also early-exercising your stock options (i.e. converting options into stock) and becoming a stockholder. If this is the case, 83(b) documentation (along with proof that it was mailed to the IRS) is essential in fighting an audit. Note that 83(b) documentation is accessible through Pulley.

If on the other hand an audit questions the eligibility of the company itself, Pulley makes it easy to look at fundraising milestones and dates of stock issuance to contest such claims.

How can I take advantage of QSBS as a founder?

First, make sure your company meets QSBS’s requirements (stated above in broad terms, see this article for detailed info), and remember that Pulley is always here to help if you are unsure.

Being QSBS eligible is a huge advantage in monetary terms, as stockholders can potentially save millions of dollars that would have otherwise been lost to taxation. If you qualify, pitch QSBS eligibility to investors and candidates as you recruit and fundraise: this is one of the big benefits of being part of an early-stage startup.

QSBS could be the cherry on top of the cake that makes you raise your next round or sign that talented engineer onto your team!

How can I take advantage of QSBS as an employee?

Ask your manager or HR whether your company is QSBS eligible (if they don’t know, remind them they can always reach out to Pulley to help them figure this out). Remember that you must hold the stock for at least 5 years before selling to take advantage of preferential tax treatment, so start the clock as soon as possible.

What this means is early-exercising your stock options and filing your 83(b) elections as soon as possible (which converts your options into stock and starts the clock).