What is a QSBS, and What are Its Benefits?

Small companies and startups are a few of the most substantial driving forces of the U.S. economy. Realizing this, the government initially put in place in 1993 an exclusion to provide for partial tax breaks on capital gains tax from selling qualified stocks from small businesses (click here). By 2010, the exclusion was expanded to 100% through the Small Business Jobs Act. Investing in QSBS, or Qualified Small Business Stocks, has become more attractive as a result.

What are the Benefits of QSBS?

For shareholders, you can enjoy up to 100% exclusion of tax on capital gains once you sell QSBS-eligible stocks. This exclusion not only benefits individuals. Encouraging more people to invest in similar stock shares can further fuel the high growth potential of small companies and startups, thereby helping the U.S. economy on a larger scale.

Do All Small Businesses Can Be Eligible for QSBS?

Not all company types are eligible for QSBS. Companies whose primary asset relies on the reputation and skill of one or a few employees won’t qualify for QSBS. These companies belong to healthcare, law, consultancy, sports, financial services, and many more. Certain company types are also in the umbrella of company types that won’t be eligible for QSBS, such as those belonging to the farming, hospitality, and banking sectors. A complete list of excluded company types is in this link provided by the IRS website.

To qualify for QSBS eligibility, the company should be incorporated as a C-corporation in the U.S. The company should maintain gross assets not exceeding $50 million at all times before or immediately after the equity issuance. Lastly, the company should not belong to the aforementioned excluded business types.

A company could lose its QSBS status if its 409A valuation changes.

How Do I Acquire QSBS Stocks?

First, you must be an individual, a pass-through entity, or a trust to hold QSBS stock. You must retain QSBS stocks for five years before qualifying for the tax benefit. If you decide to sell these stocks before the holding period elapses, your sales are subjected to the regular capital tax gain rates. You can enjoy the tax break benefit once you sell your stocks after the five-year holding period. As for securities, warrants, or convertible debt, you may convert these into stocks first to be QSBS-eligible. You may sell your stocks through bilateral secondary transactions and IPO events, aside from selling your stocks directly through typical means.

Your stocks will never lose their tax benefit status as long as the applicable provisions in Section 1202 of the tax code remain in effect. Neither will your stocks lose their tax benefit status should the company’s status change, merged with another corporation, acquired by another corporation, or if the stocks were transferred, inherited, or gifted.

How is the Tax Applied to QSBS Shares?

The capital gains exclusion is limited to ten times the adjusted cost basis or 10 million dollars, whichever is higher. Past that amount, the excess gains are subjected to regular tax rates applicable to capital gains. The time of the acquisition of the stocks also affects the tax exclusion. You may only avail of 100% tax exclusion if the stocks were acquired after September 27, 2010. If the stocks were acquired before that date, a lower exclusion percentage should be applied depending on the acquisition date.

Is the QSBS Tax Treatment Applied Uniformly Across the United States and its Territories?

The QSBS tax treatment is not applied uniformly across the U.S. If the company was incorporated in California, Alabama, Mississippi, Pennsylvania, or Puerto Rico, your stakeholders wouldn’t be eligible for QSBS exclusion. Partial conformity with the QSBS tax exclusion is applied in states such as New Jersey, Hawaii, and Massachusetts, with some modifications to the federal requirement.

Takeaways

Aside from QSBS, more options are available to maximize your assets. For any questions regarding QSBS, how to maximize your gains and benefits, its applicability, and how to manage QSBS-eligible stocks, it is prudent to seek advice from a tax expert or a qualified CPA. Knowing more about QSBS will provide you, as an investor, the flexibility to opt to invest in small companies and startups. These small companies and startups are, after all, some of the driving forces of the U.S. economy, and doing your part will surely go a long way.