Qualified Small-Business Stock, or QSBS: How to Use It

Small businesses are the heart of the American economy, generating 44% of U.S. economic activity and two-thirds of net new jobs, according to the U.S. Small Business Administration.

Though many don’t succeed, if you’re able to invest in one that does — especially a company that falls under the qualified small-business tax exemption — the potential returns and tax benefits could make the risk worth taking.

What is qualified small-business stock?

Qualified small-business stock, also known as Section 1202 stock, permits shareholders of certain qualified small businesses to exclude a significant portion of associated capital gains when selling or exchanging that stock, if shares are held for over five years. Depending on the circumstances, you could potentially write off half to all of the federal income tax owed on gains from your gross income. QSBS is typically owned by investors and employees of small businesses.

» Find out other ways to reduce capital gains tax

Here’s an example: Say you discovered a startup with a business concept likely to disrupt and revolutionize its industry. You invest $2 million into the business and receive the corresponding shares in 2015. The business takes off and you’re able to liquidate your shares for $15 million in 2021. Because the shares of this company qualify under the QSBS exemption, you’re able to pocket the $13 million capital gain without paying any taxes.

The qualified small-business stock exemption came about as part of the Revenue Reconciliation Act of 1993 to promote continued investment into small businesses and startup ventures, because they form a critical component of the economy.

How QSBS works

There are two main requirements for qualified small-business stock: The business you invest in must be qualified, and you must meet shareholder criteria to reap the tax benefits.

Identifying qualifying small businesses

In order to take advantage of the QSBS exemption, you must invest in a qualified company, which means:

• The issuer must be an active domestic C-corp. The company must be incorporated in the U.S. as a C corporation; S corporations are not permitted. The corporation also must be actively engaged in business operations as opposed to a holding company.

• The issuer’s assets must not surpass $50 million, both before and after the issuance of stock.

• The issuer’s business must not involve prohibited industries. Prohibited industries are personal services; banking, financing, insurance, investing or leasing; farming; mining; and running a hotel, motel or restaurant. Examples of industries that generally qualify include technology, wholesale or retail and manufacturing.

• The issuer must issue the stock directly. Known as the original issuance rule, the stock must be acquired directly from the issuer either in exchange for cash or property or as compensation. Employee benefits such as restricted stock units, or RSUs, options and convertible securities are allowed, but acquiring stock from another person or through the secondary markets is not.

• Note: As part of wealth transfer and charitable giving, the IRS provides an exception that enables QSBS to be gifted, subject to certain rules.

Meeting the shareholder requirements

In addition to finding an eligible company to invest in, investors must also adhere to certain rules:

• You cannot be a corporation. Only individuals, trusts or pass-through entities can benefit from the qualified small-business stock exemption.

• You must satisfy a holding period. The holding period of the stock determines the extent of a shareholder’s tax benefits:

— For stocks acquired before Feb. 18, 2009, and held for over five years, the maximum capital gains exclusion is 50%, and 7% of the gain is subject to alternative minimum tax.

— For stocks acquired from Feb. 18, 2009, to Sept. 27, 2010, and held for over five years, the maximum capital gains exclusion is 75%, and 7% of the gain is subject to alternative minimum tax.

— For stocks acquired post-Sept. 27, 2010, and held for over five years, gains are tax-free. Stocks held over a year but less than five years are subject to long-term capital gains taxes, and stocks held less than a year are subject to short-term capital gains taxes.

• There is a maximum gain cap. A shareholder can exclude any gain up to the greater of 10 times the adjusted cost basis — which is the original asset value of the investment — or $10 million.

• You may be able to defer your gain. Shareholders wanting to sell stock prior to holding it for five years can still receive tax benefits as long as the original qualified small-business stock was held for longer than six months and all proceeds are reinvested into another QSBS within 60 days.

» Learn more about tax-efficient investing

Benefits of using the QSBS exemption

The above example illustrates the rewards shareholders can potentially reap when using qualified small-business stock — that investor walked away with a $13 million gain tax-free. Being able to offer such large tax incentives means that qualifying corporations can attract investors and leverage stock as employee benefits to recruit and retain talent.

For small businesses hoping to drum up additional funding, issuing QSBS can appeal to individual investors and encourage investors to become longer-term shareholders.

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For small businesses in a growth phase, often cash can be scarce. Using stock options and RSUs as part of employee compensation packages can lure key talent and act as motivation for employees to take ownership.

Caveats to keep in mind with QSBS

Beyond dotting your i’s and crossing your t’s with the requirements outlined above, there can be situations that muddy the waters with QSBS. For instance, qualifying small businesses should be vigilant when it comes to redeeming shares (when the company forces shareholders to sell stock back to the company). Too many redemptions could invalidate the remaining stock from QSBS eligibility.