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QSBS Guide: What Is the Qualified Small Business Stock Exemption?

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 single most important 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 tax 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 gains tends to be the more common scenario for early employees and 10x cost basis may be more applicable to later stage employees that have a higher cost basis.

We’ll explain how Qualified Small Business Stock (QSBS) works and how you can ensure that you get this tax benefit when you sell. First, though, let’s take a look at some context: Why does QSBS exist at all?

Why does the QSBS Exemption Exist?

Congress enacted the Small Business Stock Tax Exemption in 1993 to encourage investment in specific types of small businesses. It did this by providing a simple tax benefit: Anyone who starts, invests in, or works for a small business can exclude certain gains from federal tax when they sell their shares (provided that they meet certain conditions–see below).

And although Congress probably didn’t have tech startups in mind when it created the Qualified Small Business exemption the year before Netscape Navigator was born, 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 Qualified Small Business Stock (QSBS)—and it is a huge benefit—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 major boon for bemployees of high-growth startups and 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 that it’s hard to beat a 0% tax rate on $10 million in gains. 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? As we’ve mentioned, the Qualified Small Business Stock (QSBS) exclusion is $10 million per taxpayer, per asset. You can multiple this exemption in multiple ways by getting multiple exemptions from the same asset (called QSBS stacking) or claim multiple exemptions with different principal assets.

Let’s look at a QSBS example! Say you are an employee of a very successful Food Delivery startup that’s 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 early exercised, 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 the QSBS exemption? If the price of the stock went up and each company’s shares were worth $10 million each, you could sell all your shares and realize up to $20 million of gains tax free. ($10 million per asset).

QSBS

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 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 QSBS stock for at least five years prior to the sale or exchange. (The clock starts from the time 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 during substantially all of the taxpayer’s holding period. This shouldn’t be a major barrier for most people; virtually all U.S.-based startups are C corporations when they take their first venture funding, and that’ll be enough to qualify as QSBS.
  • Active business and qualified trade or business requirements. At all times during the taxpayer’s holding period, the issuing company must be actively engaged in a “qualified trade or business.” Most professional service firms, finance and investment management businesses, and hospitality businesses will not qualify, but most technology companies—even tech companies serving those disqualified fields—typically are fine.
  • Small business requirement. At all times before and immediately after the issuance of the taxpayer’s stock, the corporation’s adjusted basis in its cash and other assets i.e. gross assets must not have exceeded $50 million. This provision is complicated, but a good, rough heuristic is that you will qualify if you were issued your stock before your company raised $50m in funding in a single . Still, the best way to figure this out for sure 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 income tax break on QSBS stock.

QSBS Tax Exclusion Percentage

QSBS Tax Exclusion percentage

In 2012, another key change was made that 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 extremely popular and has helped many small businesses raise capital.

The most recent changes to the QSBS rules were made in 2018 when Congress passed the Tax Cuts and Jobs Act. This legislation doubled the amount of time that investors could hold onto their stock before selling it and still qualify for the exemption. This change was made in an effort to encourage long-term investment.

FAQs

How to maximize your benefits from QSBS Tax Treatment?

  1. The first step is get in contact with someone at your company or tax expert to see if your principal asset qualifies for QSBS. You can attempt to work through the criteria yourself but external confirmation is usually helpful.
  2. There are additional strategies for maximizing the QSBS exemption on the off chance your shares are going to be worth more than $10 million. It’s known as QSBS stacking and may be incredibly valuable if you have more than $10 million of gains.
  3. 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 not everyone is a fan 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 argue that 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.

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 small 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 both invest in the same qualified small business could each exclude $10 million of their gains from taxes.

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 in order to qualify for the exclusion. This means that investors need to have a long-term horizon when they invest in qualified small 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 limits the pool of eligible companies somewhat, but there are still more than 27 million small businesses that qualify.

Recent legislative proposals to change QSBS

In the wake of the Tax Cuts and Jobs Act in 2017, there have been a number of proposals to change the QSBS rules. 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 thinking about investing in a small business.

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