Qualified Small Business Stock—what is it, and why should you care?
To incentivize investing in small businesses, Congress made permanent a law allowing investors to not pay tax on profits from the sale of small business stock as long as it fits within Congress’ definition of “qualified small business stock.” So, qualifying small businesses can issue stock with big tax benefits for the investor.
What is a Qualified Small Business?
A Qualified Small Business (QSB) is a domestic C corporation whose total gross assets do not exceed $50 million before or immediately after the corporation issues stock. “Gross assets” refers to the amount of cash and property the corporation owns.
The company must be engaged in a “qualified trade or business.” More specifically, a qualified business is any business other than those “in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees.” The definition also excludes banking, farming, hotels, and restaurants.
What is Qualified Small Business Stock?
Qualified Small Business Stock (QSBS) is any stock that a QSB issues that is acquired directly from the company for money or other property (not stock) or as compensation for services. There is no limit on how much money a QSBS raise, so long as the money raised does not take the company over the $50 million threshold for QSBs.
Why Should I Care About Qualified Small Business Stock?
QSBS comes with tax savings: purchasers can avoid tax on up to $10 million (or 10x the adjusted basis, whatever is greater) in gain on the sale of QSBS. You read that right: $10 million tax-free.
What strings are attached?
As you might imagine, this isn’t a totally amazing deal that the IRS will let just any company do; there are some limitations and requirements, both for the investor and for the QSB.
- First, there’s the five-year holding period. A taxpayer has to hang onto the QSBS for more than 5 years before they get the $10 million tax-free (also called the 100% exclusion).
- Second, to qualify for the exclusion, you have to get the stock from the company (not on the secondary market). The stock also had to be acquired from a QSB after September 27, 2010 to qualify for the 100% exclusion.
- Third, during substantially all of the time you hold the stock, at least 80% of the value of the corporation’s assets must be used in the active conduct of one or more qualified businesses (remember the list above of business that don’t qualify).
- Finally, remember that the QSB has to be under the $50 million asset threshold, both before and immediately after issuing the stock.
Here’s a table that illustrates just how powerful the exclusion is.
|Amount of Gain from the Sale of Stock||Is the Stock QSBS?||Amount Excluded for Taxation||Simplified Example Tax Rate||Final Tax Bill|
|$250,000||No||$0||23.8% of $250,000||$59,500|
|$250,000||Yes||$250,000||23.8% of $0||$0|
See here for more tax comparisons. And please note that this is a rough example—you should talk to your CPA about how these calculations would apply to your individual situation.
Technology startups are an especially exciting place for QSBS because they often see big increases in value. In addition, most technology companies are qualifying businesses. So, founders and early investors can see big, tax-free gains. However, if you live in a state with income tax, it might not have the same exclusion. For example, California no longer allows QSBS exclusions.
In short, careful planning, coupled with investment in a successful qualified small business, can produce large, tax-free gains. Startups should think about reminding their investors about this potential.
If you’d like to learn more about qualified small business stock or securities offerings generally, please contact us today.