Qualified Small Business Stock (QSBS) Rules
The qualified small business stock (QSBS) tax exclusion is a tax benefit that is designed to encourage individuals to invest in qualified small businesses (QSBs). In 1993, IRC Section 1202 was added to the U.S. tax code as part of the Revenue Reconciliation Act of 1993. It is intended to help incentivize individuals to invest in qualified small businesses (QSBs) by permitting them to realize capital gains without future tax liability as long as certain requirements are met. The QSBS exclusion was created because investing in small businesses, especially startups, can be riskier by nature, and this income tax exclusion incentivizes individual investors to take that risk.
That said, there are QSBS rules that need to be met before a company can achieve QSB status. For starters, QSBS eligibility is only attainable by businesses that do not operate in the personal and professional services realm. Examples of permissible businesses include those in the manufacturing, retailing, technology, and wholesaling industries. Businesses such as those in the hospitality, banking and financing, insurance, leasing, investing, farming, and mining industries cannot qualify as Qualified Small Businesses.
Meeting QSBS Eligibility
As generous as the QSBS tax break is, the conditions for a company’s stock meeting QSBS eligibility can be somewhat restrictive. Along with being purchased from a non-personal service providing entity, a stock needs to meet other QSBS requirements, including:
The stock issuer must be a C corporation in the U.S. (S corporations are not eligible)
The company must have less than $50 million in gross assets at the time of share issuance and immediately thereafter.
The corporation must be an active business (not a holding company) at all times that the stock is held.
Both the corporation and the shareholder must consent to provide certain documentation for the stock.
At least 80% of the corporation's assets must be used in the operations of one or more of its qualified trades or businesses.
Qualified Small Business Stock Requirements for Claiming Tax Benefits
Before an investor can take advantage of the tax benefits associated with his/her QSBS stock, the following must apply:
The investor must be an individual, trust, or other pass-through entity and not a corporation.
The stock must have been acquired in exchange for money or property or as in exchange for services provided to the corporation.
The stock must have been acquired at its original issue and not on the secondary market.
The investor must have owned the stock for at least five years.
How much of a tax exemption is available to an investor ultimately depends on when the stock was acquired and for how long it was held. According to IRC Section 1202, which was enacted in 1993, a “noncorporate shareholder can exclude 50% of the capital gain realized from the sale of qualified small business (QSB) stock that has been held for five years.” But if the QSB stock was acquired between February 17, 2009 and September 27, 2010, then the exclusion percentage is raised to 75%. For qualifying stock acquired between September 27, 2010 and January 1, 2014, the exclusion percentage is maxed out at 100%.
Section 1202 also states that the amount of gain taken into account in any given tax year is restricted to the greater of i) a $10 million cumulative limit or ii) an annual limit of 10 times the tax cost basis of QSB stock sold during that tax year.
Two Main Types of QSB Stocks
There are two primary types of qualified small business stocks for investors to choose from. The first is when startups and existing businesses that meet QSB qualifications choose to use their qualified stocks to help raise initial or additional capital to help build or expand their operations.
The second is when these companies use their qualified small business stocks as a form of payment in lieu of cash. This is commonly used to compensate employees for their services when cash flows are constrained. The stocks are also frequently offered as incentives whenever these companies try to retain employees.
Learn More About QSBS Rules and Requirements - Talk to a Pro Today!
As you can see, the QSBS rules and requirements for both corporations and investors can be complex, so if you want to learn more about them, then the best course of action is to speak to a tax professional.
The Pearl Funds is a boutique investor fund that specializes in using two separate tax incentive programs, the Opportunity Zone (OZ) program (IRC Section 1400Z) and the Qualified Small Business Stock incentive (QSBS), to yield tax-free returns in as little as five years. The Pearl Fund is a Forbes-ranked top 10 Opportunity Zone fund that is led by the country’s most well-known OZ Venture Capital fund manager. Contact us today!
