What is a QSBS, and What are Its Benefits?

What is a QSBS, and What are Its Benefits?

QSBS stands for Qualified Small Business Stocks. QSBS exclusion is a tax break that benefits qualified shareholders of small businesses (click here) and startups. Since investing in startups and small companies is riskier, the QSBS exclusion is one of the ways to encourage more people to place their trust in small companies and startups.

What are the Benefits of QSBS?

In Section 1202 of the U.S. Internal Revenue Code, the QSBS tax exclusion can potentially provide a break on capital gains tax of up to 100% from selling QSBS-eligible stocks. Originally put in place in 1993 as a partial exclusion, it has since been expanded as part of the Small Business Jobs Act of 2010. 

As a shareholder, you can unlock the full value of your equity through greater savings from selling QSBS-eligible stocks. This exclusion is an added motivation for more people to invest within the small companies they helped build or to support other small companies.

Since small companies and startups are a few of the more powerful drivers of the U.S. economy, QSBS can further fuel the growth of the innovation economy.

What Are Companies Eligible for QSBS?

Not all small companies are eligible for QSBS. Please refer to the list on this link for a complete list of company types that are not eligible for QSBS. A company can’t be qualified for the exclusion if its primary asset is the talent, skills, and reputation of one or a few of its employees. These companies belong to the law, health, sports, consulting, and financial services, among many others. This umbrella of unqualified companies includes company types that belong to the hospitality, farming, and banking sectors.

For a company to be qualified for this tax break, it should meet the following requirements:

1. The company should be incorporated as a C-corporation in the U.S.

2. The company should maintain gross assets not exceeding 50 million dollars at all times before or right after the issuance of equity.

3. As mentioned, the company should not be among the excluded business types.

A company can also lose its eligibility status. For instance, in many cases, they lose their eligibility when the company’s 409A valuation exceeds the limit. 

How Do I Acquire QSBS Stocks?

First, you should be an eligible shareholder. To be eligible, you must be a person, a trust, or a pass-through entity to qualify to hold QSBS stocks. Only stocks are qualified to be QSBS-eligible. Negotiable instruments, such as convertible debts, should be converted to stocks first to be QSBS-eligible. Once you acquire QSBS stocks, you must observe a five-year holding period before enjoying the tax break privileges. If you decide to sell these stocks before the holding period elapses, you can’t enjoy the tax breaks outlined in the provisions stated in section 1202 of the U.S. Internal Revenue Code. 

Your QSBS-eligible stocks will never lose their attributed tax benefit status as long as section 1202 of the U.S. Internal Revenue Code remains in effect as written today. Even if the company’s current QSB status changes, it has been acquired by another corporation, or the stock is gifted, inherited, or transferred, the QSBS eligibility of the stocks won’t change either.

Note that the thresholds, dates, and rules on QSBS eligibility may change. It is best to seek advice from a tax expert on how to manage your QSBS-eligible stocks.

How are QSBS-Eligible Shares Taxed?

The limit set forth by section 1202 of the U.S. Internal Revenue Code for exclusion is $10 million or ten times the adjusted cost basis, whichever is higher. Regular capital gains taxes are applied to the excess gains on the sale of shares past that amount.

The time of acquisition of QSBS-eligible stocks can also affect how they are taxed. You can only enjoy up to 100% exclusion on having to pay federal capital gains tax if you acquired the QSBS-eligible stocks after September 27, 2010. QSBS-eligible stocks acquired before that date can only have a smaller percentage of exclusion depending on the acquisition date.

Is Location of Incorporation of Companies Important?

Yes. Suppose the company was incorporated in California, Mississippi, Puerto Rico, Alabama, or Pennsylvania. Shareholders who hold QSBS stocks incorporated in those locations won’t be eligible for QSBS exclusion. Meanwhile, the states of Massachusetts, New Jersey, and Hawaii only partially conform with the QSBS tax exclusion.

Takeaways

To know more about the details of QSBS, benefits, and applicability, it is best to seek help from a tax expert or a qualified CPA. Awareness of QSBS can help small companies and startups grow by having more people trust them. As critical driving forces of the U.S. economy, supporting small companies and startups will have a farther-ranging impact beyond the benefits people will receive financially when they cash in on QSBS-eligible stocks.