Imagine a world where you can invest in a promising startup, hold onto your shares for a few years, and then, when the time is right, sell those shares and keep a significant chunk (and maybe all) of your gains out of the taxman's reach. 

Qualified Small Business Stock (QSBS) refers to shares in a qualified small business that meets specific requirements outlined in the Internal Revenue Code Section 1202, a provision that allows top earners to potentially access significant tax savings on their investments or compensation, provided they meet the following criteria: 

The company issuing the stock must be a domestic C corporation and engage in an active trade or business. Certain businesses, such as those in the service industry (law, health, finance, etc.), banking, farming, and hospitality, are generally excluded from QSBS eligibility.

The company's gross assets must not exceed $50 million when the stock is issued and immediately after the issuance.

You must acquire the stock directly from the company through purchase, exchange, or compensation for services. You can’t acquire the stock indirectly from a secondary market or third party, significantly limiting access to QSBS.

Now, here’s where the plot thickens: the stock must be held for at least five years. This holding period is critical to fully taking advantage of the tax benefits, but a lot can happen to a startup within a five-year period.

So, is QSBS worth the squeeze? Let’s explore. 

Welcome to QSBS: A Brief Introduction

There are two most likely avenues you’ll likely come into contact with QSBS: as compensation from qualified startups and existing businesses or through direct investment from similar companies aiming to raise capital through a qualified small business stock (QSBS) offering.

Qualified companies can use qualified small business stock (QSBS) as a form of in-kind payment. It’s frequently used to compensate employees when cash flow is lower. Qualified small business stock could also be used to retain employees and as an incentive to help the company grow and succeed.

The basic QSBS rule allows employees and investors to exclude up to $10 million in federal capital gains. However, the benefits can be even more substantial for investors due to the 10x investment exclusion rule; an investor initially invested $10 million in a qualified small business could potentially exclude up to $100 million in capital gains from federal taxes.

This generous exclusion is why venture capitalists (VCs) and angel investors are particularly keen on ensuring that the companies they invest in maintain QSBS eligibility. The QBS status can dramatically increase their after-tax returns. 

To protect their QSBS benefits, investors often include specific provisions in Investor Rights Agreements (IRAs), which might require the company to take reasonable actions to maintain its QSBS status and provide the necessary documentation—like a QSBS attestation letter—for investors to claim the exclusion. 

Typically, selling stock might subject an investor to short-term or long-term capital gains taxes, with rates up to 37% and 20%, respectively. 

However, QSBS allows investors to lock in a 0% federal capital gains tax rate for eligible gains, provided the shares have been held for at least five years. The exact benefits depend on when the QSBS shares were acquired.

The Considerations and Limitations of QSBS 

QSBS offers a staggered tier system based on when the stock was acquired.

Up to 100% of the gain on the sale of QSBS can be excluded from federal income taxes if the acquisition is after September 27, 2010. This is capped at the greater of $10 million or ten times the adjusted basis of your QSBS investment.

Between February 17, 2009, and September 27, 2010, that number falls to 75% of the gain can be excluded. Acquisitions before February 17, 2009, fall to 50% of the gain can be excluded.

However, it’s worth noting that the QSBS exclusion applies only to federal taxes. Alternative Minimum Tax (AMT) considerations and state taxes may still apply. 

QSB applicability can vary significantly depending on where you live. Since QSBS is rooted in U.S. federal tax law, only those who file taxes in the U.S. can take advantage of this exclusion. 

However, not all states align with federal QSBS rules, and some explicitly do not offer QSBS benefits at the state level. 

As of writing, residents in Alabama, California, Mississippi, New Jersey, Pennsylvania, and Puerto Rico aren’t eligible for QSBS tax exclusion at the state level. Hawaii and Massachusetts partially conform to QSBS rules. 

The Art of Rolling Over: A Game of Hot Potato

It’s not unheard of for a startup to start from scratch, raise capital, and build a successful business, only to find its valuation plummeting a few years later. 

The Internal Revenue Code (IRC) has a valuable tax-deferral mechanism in Section 1045, which allows you to defer capital gains when you sell QSB before meeting the required five-year holding period. 

It specifies that you can sell your QSBS and roll the proceeds into another QSBS within sixty days of the sale, deferring the tax liability until you sell the new stock. 

Still, Section 1045 still has a few criteria that must be met:

• The stock must have been acquired directly from the issuing corporation at its original issuance, either through purchase, exchange or as compensation.
• You have only 60 days after selling the QSBS to reinvest the proceeds into another qualifying QSBS to defer the gain.
• This tax-deferral option is available to individuals, partnerships, and certain trusts but not to corporations.

QSBS Liquidity

The ability to sell your QSBS can come in several ways, instead of just going public. 

A common way to achieve liquidity is through acquisition, where your QSBS could be sold as part of the acquisition, allowing you to realize gains. 

Another is selling your QSBS on a secondary market or through a private sale. Though you can sell the QSBS and claim the tax benefits (provided you meet all the criteria listed above), the purchaser won’t be able to claim the QSBS eligibility since they are buying it on a secondary market. 

Sometimes, companies offer to buy back shares from early investors and employees through a tender offer, which can also provide liquidity. 

However, if the startup goes public, you can sell your shares on the open market and benefit from the QSBS exclusion. The IPO itself isn't a requirement for liquidity, but it can offer a broader and more immediate market for selling your shares if it reaches that point. 

You have plenty of avenues to sell your QSBS, but be mindful of all the criteria, or you won’t get the benefits.

QSBS in Action

Emma files as a single individual with an ordinary taxable income of $450,000, placing her in the highest federal tax bracket for capital gains (20%). 

Emma made an angel investment in a tech startup that qualifies for QSBS. She purchased shares in this startup on October 1, 2017, and by October 1, 2023, the value of her shares had increased significantly. 

Emma decides to sell some of her QSBS shares and realizes a profit of $100,000.

Since Emma held her shares for over five years, she can exclude 100% of the $100,000 gain from her taxable income under the QSBS rules.

Normally, this gain would be subject to a 20% federal capital gains tax, resulting in a tax liability of $20,000 and an additional 3.8% Net Investment Income Tax (NIIT).

Thanks to the QSBS exclusion, Emma owes $0 in federal taxes on this gain.

Now, let’s tweak the scenario. 

Suppose Emma had bought her QSBS shares on February 15, 2011, and sold them after just four years for the same $100,000 gain. Since she didn’t meet the five-year holding period, she wouldn’t qualify for the complete QSBS exclusion. 

However, under Section 1045 of the IRC, Emma could defer the gain by reinvesting the proceeds from the sale into another QSBS within 60 days. 

This rollover allows her to continue deferring the tax liability until she sells the new QSBS shares.

Making Cents of Qualified Small Business Stock 

So, is QSBS worth it?

Absolutely—provided you can navigate its intricacies (this is where a financial planner with explicit QSBS taxation experience comes into play.)

A discussion about QSBS on a FIRE-oriented Reddit. (Source)

All things kept identical, QSBS is more advantageous than its twin ordinary stock but comes with eligibility requirements, like the minimum five-year period. 

It’s a unique amendment to the tax code that makes a winning play even better and can provide some silver lining to a lackluster return. 

 

 

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.