If you thought watching your refund add up on Turbotax was fun, wait until you learn about Qualified Small Business Stock (QSBS). While this regulation—also referred to as Section 1202—has been around since the 1990s, recent updates to its legislation have made it much more attractive to entrepreneurs, investors, as well as some employees. Essentially, QSBS allows shareholders to avoid capital gains tax entirely upon the sale of their shares. This exclusion saves shareholders thousands, in some cases millions, of dollars in taxes.
QSBS can get complicated quickly, so let’s start with some key terms and an example:
- Cost basis: the original value of an asset for tax purposes, usually the purchase price
- Capital gains: the positive difference between the sale price of the asset and its original purchase price (cost basis)
In 2012, Paige founds Startup Inc. The company is valued at $2 million and Paige owns 100% of the shares. She pays $0.10/share so her cost basis for 10,000 shares is $1,000. Through various funding rounds, the company grows to a valuation of $50 million. In 2020, Paige and investors decide to sell the company. Paige’s original shares now represent just 10% of the company, and are worth $5 million.
The sale price of her shares $5,000,000 – her cost basis $1,000 = $4,999,000 in capital gain.
Faced with a capital gain of $4,999,000, in the highest tax bracket, Paige could potentially pay $1,189,762 in taxes (capital gain x 23.8%). Fortunately, Paige consults with her accountant and learns that her shares qualify for the QSBS exemption. This means she may exclude the full $4,999,000 from the capital gains tax.
What is Qualified Small Business Stock?
Qualified small business stock is stock that receives favorable tax treatment when it meets very specific criteria. The stock must be in an active, domestic C corporation that fulfills the definition of a qualified small business (see below). QSBS was enacted in 1993 to spur investment in small businesses. It went broadly unknown for a long time but recent changes in the tax code increased the exclusion amount to 100%, which has made this strategy increasingly popular. What’s more, in 2015, the PATH (Protecting Americans from Tax Hikes) Act passed by Congress made QSBS permanent.
What does it take to qualify?
To qualify for QSBS, the following criteria must be met:
- Shareholder held the stock for at least 5 years
- Company is a domestic C corporation
- Considered original issuance stock (acquired directly from the company)
- Acquired in exchange for cash, property, or as payment for services rendered
- Aggregate value of company’s assets at the time of issuance cannot exceed $50 million
- At least 80% of the company’s assets must have been used in the active conduct of a trade or business
- A qualified trade or business is defined broadly to include any business
Reading between the lines, this means most tech, consumer, and life science companies do qualify.
Who is eligible to hold QSBS?
Generally speaking, shareholders must be non-corporate taxpayers. Examples may include:
- Early employees
Early employees should note that stock received in the form of stock options or restricted stock unit grants does qualify for QSBS but the five-year holding period does not start until the options are exercised. Thus, it’s important to pay attention to whether early vesting or early exercising is an option at your company.
How does the exclusion work?
The QSBS exclusion is limited to the greater of $10 million or 10x the taxpayer’s cost basis in the stock. Any excess gain is taxed under the normal applicable rules and may be subject to the maximum rate on capital gains.
The exclusion percentage is determined by when you acquired equity in the company and only applies to stock issued after August 10, 1993. For stock purchased after September 27, 2010, 100% of the capital gain is eligible for exclusion and 0% of the gain is subject to AMT. For stock purchased before September 27, 2010, the amount of capital gain that can be excluded ranges from 50% to 75%.
Stock received in a tax-free acquisition gets special QSBS treatment as well, even if the stock in the acquiring company would not otherwise qualify as QSBS. This is important to keep in mind for companies that get acquired before the five-year holding period. The new stock will continue to qualify as QSBS up to the amount of gain at the time of the acquisition.
Unfortunately, not all states adhere to QSBS provisions in the IRS tax code so shareholders may be required to pay state income taxes on their gain. The tax regulations and specific requirements to qualify for QSBS will vary from state to state.
Multiplying the exclusion
Often referred to as “stacking,” this powerful estate planning strategy is a mechanism by which creating trusts can exclude further gains from being taxed.
For example, let’s say that when Paige sold her company, she received $30 million for her 10% ownership of QSBS shares. On her own, Paige only qualifies for the $10 million exemption. However, Paige is married with a child. She wants to set up a trust for her husband and a trust for her child. If each trust qualifies as a second taxpayer, it will receive its own QSBS exemption. This would allow Paige to fund both trusts with the full exemption amount. Thus, Paige is able to exclude the full $30 million gain from capital gains tax.
How do I ensure I get the exclusion?
In order to obtain the exclusion, you must provide adequate information at the time of sale. So make sure you are diligent about the following:
- Verify if your company qualifies for QSBS status
- If so, document your purchase of shares:
- The date purchased
- The amount paid
- Copy of the check or wire used to pay for stock
- Copy of the share certificate
- Consult a tax professional before you sell—it will be well worth it!
If you are a founder or an investor, Section 1045 of the IRS code is another regulation that may provide significant value to your portfolio, particularly if you are fortunate enough to experience an exit before the five-year holding period is met.
Under Section 1045, if QSBS is held for more than six months, the seller may elect to defer realized gain by reinvesting the sale proceeds into a new QSBS opportunity within 60 days. The seller’s basis in the new stock is reduced by the amount of gain deferred.
For a serial entrepreneur or angel investor, this means you can move from one business venture to the next without having to pay immediate taxes on the proceeds of the first venture. However, Corporations are excluded from utilizing this strategy.
The impact of QSBS is far-reaching, as it not only applies to many different industries but also several types of shareholders. The regulation is predicated on shares deemed original issuance (acquired directly from the company), which could be the case whether you are an employee, a founder, or an investor.
It’s worthwhile to learn whether your shares qualify for QSBS status; and in the event they do, remember that the timeline is equally essential to receiving the exclusion. The result could be more than 20% in tax savings!
Fidelity does not provide legal or tax advice. The information herein is general in nature and should not be considered legal or tax advice. Consult an attorney or tax professional regarding your specific situation. Turbotax and Fidelity are not affiliated. Sample scenarios are for illustrative purposes only.