Qualified Small Business Stock (QSBS)
What is QSBS?
Startup founders, employees, and investors can all benefit from owning “Qualified Small Business Stock” (QSBS). QSBS refers to the tax exemption found in Section 1202 of the US tax code that enables each taxpayer to receive tax-free gains from the sale of stock, up to the greater of (i) $10 million, or (ii) 10x their original investment.
To qualify for the tax-saving benefits of QSBS under Section 1202:
1. You must acquire original, issued shares
For employees, options give you the right to purchase shares but are not shares. Options can therefore not be eligible for QSBS until you execute them.
The IRS has not yet resolved whether shares that you possess through a SAFE can qualify as QSBS. Is a SAFE considered equity at the original date, or is it a prepaid contract until the SAFE converts into shares of stock? In many circumstances, the issue of whether a SAFE was “stock” for QSBS purposes will depend on the specific nature of the contract used, particularly its beginning date. If you find yourself in this situation, proceed with caution and consult your tax adviser as this area of tax law is as yet unsettled.
2. They must be directly from a qualified small business taxed as a C-corporation
Most technology startups will qualify for QSBS treatment. However, there is a lengthy list of companies whose shares are not allowed to receive the QSBS status .
3. The business must have no more than $50 million in aggregate gross assets at the time of issuance
The key question in the venture industry typically falls on whether the company had “aggregate gross assets” of $50 million or less at the time of investment. Many people assume valuation is important, but it is not. “Aggregate gross assets” simply means the amount of cash and property held by the company. The key sum for QSBS qualification is the cash invested in a fundraising round plus the assets on a company’s balance sheet.
4. You must hold onto such shares for at least 5 years
To qualify for QSBS tax preference, you must hold your stock for at least 5 years. Selling it early may void your tax benefit. As a small bit of nuance, if you have held your shares for at least 6 months but not yet 5 years, you may be able to roll your gains into a replacement QSBS company within 60 days of exit.
Reporting QSBS on your income
If your stock meets those four requirements, you will likely be eligible for QSBS tax treatment. This means you may not owe any Federal taxes (~23%) on the gains from the sale of your stock (up to the greater of (i) $10 million, or (ii) 10x your original investment).
The reporting requirements for QSBS are surprisingly easy. There is no special filing, elective form, or other notice until you liquidate the asset. Upon an exit, most companies may not even mention it. Rather, to claim QSBS status, you simply report the sale of QSBS on Schedule D (of Tax Form 1040) and Form 8949 like any other capital gain. Then, the IRS generally has three years to request additional reports or audit your activities.
Even though reporting QSBS is simple, you should still keep financial statements and other supporting documents to support your claim. Detailed balance sheets for the company from its incorporation through the close of your investment will show if it has more than $50 million in aggregate gross assets. Equity documents (type, date, etc.) are also important to demonstrate that your investment qualifies.
While QSBS is most commonly used up to $10 million, there are ways to capture even more upside.
Some founders start their companies as LLCs, grow the valuation, and then convert the entity to a C-Corp. This conversion has lots of nuance, but may lead to a 10x in potential QSBS benefits. If executed correctly, the conversion may trigger QSBS treatment on 10x the value of the company at its conversion, which could be much higher than $10 million. (If the company was worth $10 million at its conversion, it may be eligible for up to $100 million in QSBS benefits.)
For venture funds, QSBS applies per portfolio company for each limited partner. Thus, each investment is an opportunity for up to $10 million in tax free gains for each LP.
Owners of QSBS-qualified shares are also allowed to gift shares into trust while retaining the QSBS status. Through a process known as “trust stacking,” a parent may transfer stock to multiple children in trust with each beneficiary getting up to $10 million of tax-free gains.
These types of companies are not eligible for QSBS:
- Any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business in which the principal asset of such trade or business is the reputation or skill of one or more of its employees;
- Any banking, insurance, financing, leasing, investing, or similar business;
- Any farming business (including the business of raising or harvesting trees);
- Any business involving the production or extraction of products of a character with respect to which a deduction is allowable under section 613 or section 613A (i.e., oil or gas properties subject to depletion); and
- Any business of operating a hotel, motel, restaurant, or similar business.