Using the Qualified Small Business Stock Exemption, or QSBS, you can pay 0% federal and state taxes on most of your startup or small business equity if you have held it for five years.
What Is QSBS?
The Qualified Small Business Stock Exemption, or QSBS, is the most critical tax benefit for many startup founders, investors, and employees. The QSBS rule allows some owners of startup equity to eliminate 100% of their federal income and state income tax on the greater of their first $10m of gains per asset or 10x the cost basis of an asset. Generally, $10m of profits tends to be the more common scenario for early employees. However, a 10x cost basis may be more applicable to later-stage employees with a higher cost basis.
We’ll explain how Qualified Small Business Stock (QSBS) works, how you can ensure that you get this tax benefit when you sell, and how it impacts your ordinary taxable income. First, though, let’s examine some context: Why does QSBS exist?
Why does the QSBS Exemption Exist?
Congress enacted the Small Business Stock Tax Exemption in 1993 to encourage investment in specific businesses. It did this by providing a simple tax benefit: Anyone who starts, invests in, or works for these businesses can exclude certain gains from federal tax when they sell their shares (provided they meet certain conditions–see below).
The Congress probably didn’t have tech startups in mind when it created the Qualified Small Business exemption the year before Netscape Navigator was born. But the exemption applies to shares in all kinds of “small” businesses, including young tech startups (and Congress confirmed as much when it renewed the exemption as part of the Small Business Jobs Act of 2010).
How does QSBS Work?
Today, the primary benefit for holders of QSBS—a considerable advantage—is the zero-percent capital gains tax rate on eligible gains up to $10 million per company (or 10x your investment, whichever is higher) per person. We don’t have to tell you that this tax break is a significant boon for employees of high-growth startups due to their ordinary taxable income, as well as small businesses incorporated as C Corps. And it applies to most equity earned during a company’s early years.
What are the tax benefits from QSBS?
You might imagine beating a 0% tax rate on $10 million gains is hard. And you’d be partly right: If you live in a high-tax state, that could mean an extra $3.7 million in your pocket.
But what if there were a way to multiply that exemption? The Qualified Business Stock (QSBS) exclusion is $10 million per taxpayer per asset. You can use multiple this exemption by getting various exemptions from the same asset (called QSBS stacking) or claim numerous exemptions with different principal assets.
Who benefits from QSBS?
There are a few different groups of people who typically benefit from the QSBS exemption:
- Entrepreneurs and small business owners who are looking to raise capital
- Small business and venture investors
- Employees of businesses who receive stock options as part of their compensation package
The QSBS exemption allows investors to exclude a portion of their gains from taxation when they invest in qualified small businesses. If a company meets these requirements, investors can exclude up to $10 million of their gains or 10x their investment, whichever is higher, from taxation. This exclusion is per investor, so a husband and wife who invest in the same qualified small business could each exclude $10 million of their gains from taxes.
Let’s look at a QSBS example!
Qualified Business Stock Example
Say you are an employee of a very successful Food Delivery startup nearing an IPO. But before that, you worked for a fast-growing Data Analytics start-up. Let’s assume you paid next to nothing for your shares because you exercised early, and today each company’s stock is worth $5 million (that’s a total of $10 million between the two).
First off, congratulations, you’re receiving a massive landfall, but what does this mean for applying for the Qualified Small Business Stock exemption? If the stock price went up and each company’s shares were worth $10 million, you could sell all your shares and realize up to $20 million of gains tax-free. ($10 million per asset).
What Are The Requirements for Qualified Small Business Stock (QSBS)?
The tax code rules on QSBS tax benefits can be tough to follow–shocker, we know–and there are nuances to the requirements. We’ve done our best to make them digestible here, but please reach out if you have questions, and we’ll gladly help you understand if your shares are eligible and how to stack your QSBS exemptions.
- Original issue requirement. The taxpayer must have received the stock at the original issue from the company (that is, not in a secondary sale) in exchange for money, other property, or services. Most equity grants to founders, employees, and investors will qualify.
- Five-year holding period. The taxpayer must have held the Qualified Small Business Stock for at least five years before the sale or exchange. (The clock started when the stock was exercised, not when it was granted.)
- Domestic C corporations only. The issuing company must be a domestic C corporation at the time of issue, at the time of the taxpayer’s sale or exchange, and substantially all of the taxpayer’s holding period. This shouldn’t be a significant barrier for most people; virtually all U.S.-based startups are C corporations when they take their first venture funding, which will be enough to qualify as QSBS.
- Active business and qualified trade or business requirements. During the taxpayer’s holding period, the issuing company must engage actively in a “qualified trade or business.” For example, most professional service firms, finance, investment management, and hospitality businesses will not qualify, but most technology companies—even those serving those disqualified fields—are typically fine.
- Business requirement. At all times before and immediately after the issuance of the taxpayer’s stock, the corporation’s adjusted basis in its gross assets, including gross income, must not exceed $50 million. This provision can be complicated, but a good, rough heuristic is that you will qualify if you were issued your stock before your company raised $50m in gross income in a single round. Still, the best way to figure this out is to ask your company’s finance team.
- State tax rules: Most states follow the federal QSBS tax code rules and exempt qualified gains from state taxes as well. But some states–California and Pennsylvania, for example–don’t, and others, such as New Jersey, impose additional requirements to receive a state and a federal income tax break on QSBS stock.
QSBS Tax Exclusion Percentage
In 2012, another fundamental change allowed investors to reinvest their gains into another QSBS and still receive the tax exclusion. This “rollover” provision, read our article about QSBS rollovers here to learn more, has been prevalent and has helped many of these types of businesses raise capital.
The most recent changes to the Qualified Small Business Stock rules were made in 2018 when Congress passed the Tax Cuts and Jobs Act. This legislation doubled the time investors could hold onto their stock before selling it and still qualify for the exemption. This change was made to encourage long-term investment.
Is QSBS taxed at 28%?
Yes, the QSBS tax benefit is subject to a taxation of 28%. When the QSBS is sold, the investor may be subject to regular federal income tax on the gain. Additionally, the investor may also be subject to the alternative minimum tax (AMT) at the rate of 28% on the increase, which is equal to the excess of the stock’s fair market value over its original cost basis. For this reason, investors should consider the potential alternative minimum tax (AMT) implications of their QSBS investments.
How to maximize your benefits from QSBS Tax Treatment?
- The first step is to contact someone at your company or a tax expert to see if your principal asset qualifies for QSBS. You can try to work through the criteria yourself, but it’s usually helpful if you don’t mind me asking.
- There are additional strategies for maximizing the QSBS exemption on the off chance your shares will be worth more than $10 million. By stacking QSBS shares, you can substantially exceed the $10 million limitation and dramatically reduce your gross income taxes. This strategy may be precious if you gain more than $10 million.
- In short, getting started early on QSBS –even if it’s only the planning phase, will help you avoid missing out on these potentially life-changing tax savings.
Why is QSBS controversial?
But only some people are fans of the Qualified Small Business Stock tax treatment. Some critics argue that it disproportionately benefits wealthy investors and hurts state and local governments by reducing tax revenue. Others say it’s just another example of the internal revenue code giving an unfair tax code benefit to those who can afford to invest in small businesses.
What are the challenges with QSBS?
While the QSBS exemption is a powerful tool for small businesses and investors, there are a few potential risks to be aware of. First, the stock must be held for at least five years to qualify for the exclusion. This means that investors must have a long-term horizon when investing in qualified businesses. Second, the company must use at least 80% of its assets within the United States. This can be a challenge for companies with global operations. Finally, the company cannot be a publicly traded corporation. This somewhat limits the pool of eligible companies, but more than 27 million small businesses still qualify.
Recent legislative proposals to change QSBS
In the wake of the Tax Cuts and Jobs Act in 2017, several proposals have been made to change the QSBS rules. For example, some lawmakers have proposed repealing the exemption entirely, while others have suggested capping the capital gain amount that can be excluded or changing the holding period requirements. So far, none of these proposals has gained much traction, but it’s something to keep an eye on if you’re considering investing in this type of business.
- QSBS Stacking: How to Stack Up the Benefits?
- Case Study: QSBS benefits with a Charitable Remainder Trust
- Mastering QSBS Packing
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