Understanding Qualified Small Business Stock (QSBS): Definition, Requirements, and Tax Benefits
Business owners don’t always consider their exit plans when first forming their company and selecting an entity type, and it can cost them hundreds of thousands of dollars down the road!
This is why you should always have an end goal or idea in your head. If you’re building a company with the intention to eventually sell it, then Qualified Small Business Stock (QSBS) is something you need to know about before even starting, ideally.
Under certain circumstances, QSBS can offer significant tax advantages for eligible businesses and investors, but understanding the important information and requirements is crucial to setting up your goals effectively.
In this article, we will provide you with a comprehensive overview of QSBS, including the criteria to be met to qualify for it and its tax benefits.
Whether you are a business owner or an investor, this article will give you valuable insights on how QSBS works and how you can maximize its benefits.
If you need further assistance, you can also schedule a call with us here at Compass CPA to navigate through complex situations related to QSBS and taxes.
Read on to learn more about these tax benefits and how they can potentially benefit your business or investment endeavors.
What is QSBS
QSBS stands for Qualified Small Business Stock and refers to the shares issued by small businesses that meet specific criteria defined in the tax code and are qualified for the exclusion of up to $10 million of capital gains when sold under the right circumstances.
The rules and requirements for QSBS tax exclusion are outlined in Section 1202 of the U.S. Internal Revenue Code. However, certain types of businesses, such as healthcare companies, professional sports organizations, farming, mining, financial services, investing businesses, and law firms, are ineligible for QSBS.
The QSBS tax exclusion is applied to motivate investors to support the small businesses they have contributed to. In fact, this benefits the economy as a whole, as shareholders are encouraged to invest more in the future potential of small businesses and reap the full value of their stock.
Moreover, in order to qualify for QSBS tax exclusion, one criterion is that you must own actual stock shares, as opposed to options or other types of securities like warrants.
Who should consider QSBS?
In an ideal scenario, an entrepreneur who is thinking about starting a business consults a tax professional who explains QSBS and advises them properly regarding entity selection for QSBS optimization. However, this happens less than 50% of the time, in reality. If you are a current or future business owner who plans to sell part or all of your stock at some point in the future, then you should consider QSBS.
If you’re an early-stage investor, you should be pushing for the portfolio company to already be optimized, if possible, for QSBS before you invest.
If you’re someone who would rather keep money in their pockets than pay it to the IRS, then QSBS is for you. QSBS can provide you with potential capital gains tax exclusions, which can result in significant tax savings upon the sale of your eligible small business stock.
Tax Benefits for QSBS
The primary incentive for investing in QSBS is the potential for exclusion of gain on the sale of qualified stock.
Shares can often be subject to either short-term or long-term capital gains rates when sold. Long-term capital gains rates can reach 20%, while short-term capital gains rates can reach 37%. The QSBS classification allows one to guarantee a federal capital gains tax rate of 0% on a healthy portion of the gain.
Nevertheless, the tax advantages vary depending on when the QSBS shares were purchased. This is one of the limitations of the tax benefits that one can enjoy when opting for QSBS which will be discussed later on.
Under the current tax law, if you hold QSBS for at least five years, you may be eligible to exclude 100% of the gain realized from the sale of the stock, up to a maximum of $10 million or 10 times your basis in the stock, whichever is greater.
This exclusion applies to both federal and most state capital gains taxes, providing a significant tax advantage for qualifying investors.
For example, you purchase QSBS for $1 million and sell it after five years for $11 million. In that case, they could potentially exclude the entire $10 million gain from the taxable income, resulting in substantial tax savings.
However, it's important to keep in mind that any gain above the exclusion limit will be subject to regular capital gains tax rates.
Basic Requirements for QSBS
Under IRS rules, not all small businesses can be qualified.
To qualify for QSBS, here are the several requirements that you, as the company issuing the stock, and your investor must meet:
Some of the key requirements include:
Qualified Small Business: Your company must be a domestic C corporation and have total gross assets of $50 million or less at the time of stock issuance.
Qualified Trade or Business: Your company must use at least 80% of its assets in the active conduct of a qualified trade or business.
Stock Issuance: The investor must purchase the stock directly from your qualified small business in exchange for money, property, or as payment for services. It cannot be acquired through the secondary market, a stock option, or convertible debt.
Holding Period: You must hold the QSBS for at least five years to be eligible for the exclusion of gain on the sale of the stock.
Limitations and Considerations
While QSBS can provide significant tax benefits, there are some limitations and considerations that you should be aware of:
Timing: Only stock purchased after September 27, 2010, and before January 1, 2022, is subject to the 100% exclusion of gain on QSBS.
Holding Period: You must hold the QSBS for a minimum of five years in order to be eligible for the exclusion of gain. The gain will be taxed at regular capital gains rates if the stock is sold before the five-year holding period. This is why every year counts.
Alternative Minimum Tax (AMT): The exclusion of gain on QSBS does not apply to the alternative minimum tax (AMT). If an investor is subject to AMT, they may still be liable for tax on the gain.
Location: Only employees who are U.S. taxpayers are eligible to use QSBS because it is a modification to the U.S. tax code. Some states do not follow the federal tax code, even though many state authorities do.
As of now, you (the shareholder of the company stock) are not qualified for the QSBS tax exclusion at the state level if you live in one of the following states or territories:
Alabama
California
Mississippi
New Jersey
Pennsylvania
Puerto Rico
Massachusetts and Hawaii both partially abide by the QSBS tax exception. Depending on where the company was incorporated (for the firm) and where the shareholder resides (for the shareholder), different rules apply.
Important Dates & Tax Rules for QSBS
For QSBS acquired after September 27, 2010:
100% exclusion of any gain
For QSBS acquired between February 18, 2009, and September 27, 2010:
75% exclusion of any gain
25% of the gain will be included in taxable income
For QSBS acquired before February 18, 2009 but after August 10th, 1993:
50% exclusion of any gain
50% of the gain will be included in taxable income
Bottom Line
It is important to keep in mind that the rules and regulations around QSBS can be complex, and eligibility requirements may vary depending on various factors. Additionally, there are QSBS exemptions and limitations that you have to consider.
As tax laws and regulations are subject to change, Compass CPA is here to help you analyze your specific situation and develop a strategy that aligns with your business goals and financial objectives.
Consult with our qualified accounting and tax professionals, who can help you determine if QSBS is suitable for your business and how to start with your tax planning. We also provide several accounting services that will surely improve your business's accounting.
So, if you are looking for advanced strategies to maximize the benefits of QSBS, Compass CPA is here to help you!