What is a QSBS?
QSBS (Qualified Small Business Stocks) are stocks invested in Qualified Small Businesses (QSBs) that benefit qualified shareholders through tax exclusions of up to 100% from paying capital gains tax. The reason for its establishment is to provide additional motivation for people to invest in small companies and startups, which are considered riskier ventures.
What are the Benefits of QSBS?
Passed in 1993, Section 1202 of the U.S. Internal Revenue Code allows eligible shareholders to avail of up to 100% exclusion of tax on capital gains as expanded through the Small Business Jobs Act of 2010.
With substantial tax breaks from potentially not having to pay for capital gains, qualified stakeholders can unlock the maximum benefits of their equity. With more people encouraged to invest in small companies (click here) and startups, these will help fuel the growth of the U.S. company at large.
Which Companies are Eligible for QSBS?
A company qualifies for QSBS () if it satisfies the following eligibility rules:
The company should be incorporated as a C-corporation in the U.S.
The company's gross assets should not exceed $50 million before or right after the equity issuance.
The company should not be among the excluded types of companies.
To answer item #3, companies that count as their principal assets are the talent, reputation, or skill of one or a few of their employees. These include companies belonging to law, health, sports, financial services, and many others. Businesses in the banking, farming, and hospitality sectors, such as restaurants, are also included in the umbrella of companies excluded from QSBS eligibility.
A company may lose its QSBS eligibility if its 409A valuation changes. However, stakeholders may still exercise their grants within the time window while the company is still eligible.
How do I Acquire QSBS Stock?
For starters, you must be a person, a trust, or a pass-through entity to hold QSBS stocks. Please note that securities and other negotiable instruments such as warrants, convertible debt, and other options should be converted to stocks before being QSBS-eligible.
Another caveat is that the stocks can't be QSBS-eligible until a qualified shareholder has owned them for at least five years. Until the holding period elapses, you can't qualify for the tax benefit.
Once the holding period elapses, you may avail of up to 100% exclusion from paying capital gains from federal taxes through bilateral secondary transactions, direct selling, IPO events, or other ways of selling private company stock.
Once the stocks are QSBS-eligible, they will never lose their attributed tax benefit status even if the current QSB status of the company changes. For instance, if the company was acquired by another corporation or involved in a merger, or if the eligible QSBS sticks are transferred through being gifted and inherited, their stocks will still be QSBS-eligible.
How are QSBS Shares of Stocks Taxed?
The extent of federal capital gains exclusion is $10 million or ten times the adjusted cost bases, whichever is greater. However, should the sale amount exceeds this, the regular capital gains tax rates apply to the excess gains.
Moreover, you can maximize the gains only if the qualified QSBS shares were acquired after September 27, 2010. If the stocks were acquired before that, only a smaller percentage of exclusion is applied, depending on when the stocks were acquired.
Does The Same QSBS Regulation Apply Throughout the U.S.A.?
No. Suppose the company that issues the stocks were incorporated in Alabama, California, Mississippi, New Jersey, Pennsylvania, or Puerto Rico. In that case, the stakeholders won't be eligible for QSBS exclusion at the state level. States such as Hawaii and Massachusetts only partially conform with the QSBS tax exclusions and have different regulations.
Takeaways
QSBS is one of the benefits often overlooked by many holding stocks in small companies and startups. Awareness of your assets through seeking advice from a qualified CPA and a tax advisor is one of the keys to unlocking the benefits of your assets, such as QSBS. If you are aware of QSBS, the government provides these benefits to help innovation and economic growth by building investment opportunities for many people to help startups and small businesses. QSBS are not just instruments that benefit individuals. These are also tools that can help the U.S. economy grow as well.