What is a QSBS, and What are Its Benefits?

What is a QSBS?

If you are a stockholder in a qualified small business (QSB), the U.S. Revenue Code provides a way to maximize your gains through the sales of your qualified small business stock (QSBS) in the form of tax breaks from paying capital gains. QSBS is one of the ways to encourage people to invest in small businesses (click here) and startups, which are considered riskier. QSBS provided a partial exclusion for eligible small business stocks in 1993, which was expanded in 2010 to potentially cover 100% of exclusions.

How Does QSBS Benefit You?

Here are some QSBS benefits. With QSBS-eligible stocks, you can unlock tremendous potential from your equity from the startups and small businesses you helped build. With small companies being an essential foundation of the U.S. economy, having more people encouraged to invest in these small companies allows the U.S. economy to grow. 

Which Company Types are Eligible for QSBS?

QSBS allows stakeholders in a wide variety of companies to maximize the value of their stocks once they sell them. However, there are strict qualifications for companies to be eligible for QSBS:

1. These should be C-corporation U.S. companies
2. Their gross assets should not exceed $50 million before and right after issuing the equity
3. The company should not belong among the excluded types.

Excluded companies rely on one or more of their employees’ talent, skill, and reputation. For instance, companies that are in the following sectors are excluded from being eligible for QSBS:

• Sports companies
• Consulting companies
• Health-related
• Financial services
• Engineering
• Farming
• Hospitality services
• and more.

For a complete list of excluded business types, you may refer to this link published by the IRS. However, you may also consult with your tax expert to inquire if the company you invest in is eligible for QSBS.

A company might be disqualified for QSBS status if its 409A valuation increases. However, you may still enjoy its benefits within the time window.

How Do You Acquire a QSBS-Qualified Stock?

To qualify to hold a QSBS stock, you must be an individual, a trust, or a pass-through entity. Other types of securities and negotiable instruments, such as convertible debt, and warrants, do not qualify until they are converted into stocks (which may include ISOs, ISO/NSO splits, and others). Once a qualified stakeholder holds on to these stocks, they should hold on to them for five years to qualify for the benefits outlined in Section 1202 of the U.S. Internal Revenue Code. Your stocks will still be subjected to capital gains tax if you sell them before the maturity period elapses. However, once the holding period elapses, you can enjoy the benefits through tax exclusions from capital gains through many stock selling options such as tender offers, bilateral secondary transactions, and directly selling them. As long as Section 1202 of the tax code remains in effect as it is currently written, your QSBS stocks won’t lose their eligibility. Moreover, your stocks’ eligibility won’t be affected if it was transferred through inheritance, as a gift, or in other ways.

How are QSBS Taxed?

If you acquired qualified QSBS stocks after September 27, 2010, you might avail up to 100% in tax breaks. However, eligible stocks acquired before that date will have a lower percentage of tax breaks depending on the date of acquisition. The baseline of federal capital gains exclusion for QSBS-qualified stocks is ten times the adjusted cost basis or $10 million or whichever is higher.

Is the QSBS Tax Treatment Depend on Where The Company Is Incorporated?

If the company is incorporated in California, Alabama, Mississippi, Pennsylvania, New Jersey, or Puerto Rico, the shareholders won’t be eligible for exclusions at the state level. Meanwhile, different rules are applied for QSBS tax exclusion in states such as Hawaii and Massachusetts.

Takeaways

Innovation and enterprise are just a few endearing characteristics of the U.S. economy. QSBS is an excellent opportunity presented for people to encourage them to support small businesses and startups. QSBS is one way the government motivates people to support the U.S. economy. Moreover, QSBS is also a way of freeing up more funds for people who want to cash in on their gains from investing in small companies and startups. Consulting a tax expert or a qualified CPA is an excellent choice for people who want to know about QSBS and how to capitalize on them.