What is QSBS?: Our Guide to Understanding This Complex Tax Break for Early Investors
You don’t need us to tell you that tax breaks are a good thing for investors—reducing your tax liability can help your investments pack a bigger punch. That’s where the qualified small business stock (QSBS) exclusion can come in handy. It allows eligible investors to avoid paying a large chunk of capital gains tax when selling qualified stock.
The QSBS exclusion has eye-popping benefits if the stars align: potentially $10,000,000 of gain on your investment excluded from taxes. You read that right, if all of the qualifications detailed below are met, investors have the potential to avoid paying tax on ten million dollars of gains.
This type of stock is issued by certain small businesses as a way of generating capital and attracting a loyal pool of employees. It’s a win-win for both parties. Shareholders are incentivized to invest, while small businesses receive essential funding as they grow.
It's simple enough, but the QSBS exclusion comes with a lot of stipulations. Let’s break down what it is and, most importantly, how both small businesses and investors can use it to their advantage.
Why the QSBS Exclusion Exists
Before we get into the finer details, let’s talk about why this tax exemption exists in the first place. Section 1202 of the tax code, which encompasses the QSBS exclusion, was introduced with the Revenue Reconciliation Act of 1993. It was designed to encourage folks to invest in startups and small businesses to fuel economic growth.
It also has perks for employees. It isn’t uncommon for workers to own qualified small business stock. It can be a unique employee benefit that helps small businesses draw in essential talent. And since QSBS stock must be held for several years in order to reap the full tax exemption, it can serve as a strong employee retention tool. Companies don’t need to issue any special kind of stock but employees should know that if they are issued stock options, they must first exercise and pay for the options so that they become the owner of those shares.
What Must Companies Do to Meet the Qualifications?
The qualified small business designation is good news for cash-strapped entrepreneurs. If your business meets the criteria, it could help with both recruitment and long-term funding. The U.S. Small Business Administration points to these key requirements:
The business must be an active C corporation based in the United States. (Holding companies do not qualify.)
Since forming, business assets must not exceed $50 million. So if you get a big surge of capital and your assets begin surpassing that amount, stock issued after that point will not qualify for QSBS status.
The company cannot involve personal services (banking, financing, leasing, insurance or investing), farming or mining, or hospitality sectors like restaurants, hotels or motels. However, businesses involving manufacturing, technology, retail or wholesale are allowed.
Stock must be issued in exchange for money or property. It can also be included as part of employee compensation. Either way, it must be a direct exchange. If an investor acquires QSBS stock through someone else or on a secondary market, they will not receive the tax break. One exception is if QSBS is being gifted, which is allowed in certain situations.
How Can Investors Meet the Qualifications?
Investors must meet requirements on their own to take advantage of the QSBS tax exemption. This is dependent on two key factors—when the QSBS stock was acquired and how long it was held. No matter what, the portion of gains sheltered from taxes is limited to either $10 million or 10 times the original asset value (whichever is more).
Here’s how it all shakes out, according to the U.S. Small Business Administration:
If you acquired QSBS stock after September 27, 2010: You can avoid all capital gains tax if you hold the stock for over five years. Long-term capital gains tax applies to stock held for over one year but no more than five years. Meanwhile, short-term capital gains tax is tacked onto QSBS stock held for a year or less.
If you acquired QSBS stock between February 18, 2009 and September 27, 2010: 75% of gains are excludable from gross income. It’s also worth noting that alternative minimum tax will apply to 7% of the gain.
If you acquired QSBS stock before February 18, 2009: You’ll be on the hook for paying capital gains tax on 50% of gains. The alternative minimum tax also applies to 7% of gains.
There is one semi-loophole for investors who are looking to sell QSBS stock but haven’t yet held it for five years. If you hold it for over six months, sell it, and then reinvest the proceeds into another qualified small business within 60 days, you can defer your gain.
The most powerful way to maximize QSBS stocks is to hold them for as long as possible. Again, you’ll get the largest tax break by holding out for at least five years. You’ll also want to clarify which stocks in your portfolio, if any, qualify for QSBS status so that you don’t miss out on these key tax breaks. When buying QSBS stock, both the investor and the business must provide certain documentation, so be sure to read the fine print.
It's also worth noting that some potential changes to the QSBS exclusion could be on the horizon. In the fall of 2021, a piece of legislation called the Build Back Better Act proposed scaling down the tax break. For example, for QSBS stock sales after September 13, 2021, taxpayers whose adjusted gross income is $400,000 or more would only get a 50% exclusion rate (as opposed to 100%). The legislation might also change how QSBS relates to estate planning. The Build Back Better Act is still a proposal and has not been signed into law, but it’s something to keep an eye on. All in all, the QSBS exclusion has a lot of moving parts. We’re here if you have questions about what it means for your big-picture financial plan.