Qualified Small Business Stock (QSBS) provides startups and investors with valuable tax benefits, including potential exclusion of up to $10 million in capital gains. In this guide, we’ll cover what QSBS is, how companies and investors qualify, and common pitfalls to avoid so your business can make the most of these advantages.
What is QSBS?
QSBS, or Qualified Small Business Stock, is a unique tax benefit under Section 1202 of the Internal Revenue Code. For eligible companies, QSBS allows investors to exclude up to the greater of $10 million or 10 times the investment from federal capital gains tax if they hold the stock for five years. This can result in substantial savings for both founders and investors, making it an essential consideration in startup financing and growth.
What Are the Requirements to Qualify as a QSBS?
To qualify for QSBS, a company must meet several requirements at the time of stock issuance:
- Entity Type: Only C-Corporations qualify. LLCs and S-Corps are ineligible, although LLCs can typically convert to C-Corps to become eligible (with a new holding period starting upon conversion).
- Business Type: The company must be an active, qualified trade or business, typically excluding service-based industries like law, finance, and healthcare.
- Asset Limits: The company’s gross assets must be under $50 million at the time of stock issuance, which includes all assets held by the company before and after issuance (i.e. inclusive of funds invested to purchase stock)..
- Original Issuance: Investors must acquire QSBS directly from the company rather than through a secondary sale or transfer.
For a comprehensive checklist, check out this QSBS checklist by Baker Tax Law.
Potential Pitfalls in Securing QSBS Eligibility
Maintaining QSBS eligibility requires ongoing compliance and monitoring. Here are some common pitfalls that can jeopardize QSBS status:
- Entity Structure: Only C-Corps qualify, so ensure the company structure aligns with QSBS requirements from the outset.
- Holding Period for Converted LLCs: For LLCs converting to C-Corps, the five-year holding period starts upon conversion—not the original issue date.
- Significant Redemptions: Large stock repurchases can disqualify QSBS eligibility, which can impact not only the individual stockholder but also all stockholders issued stock for a period before or after the redemption. All repurchases of stock should be reviewed to ensure that the repurchase is not a significant redemption.
- Original Issuance Requirement: QSBS must be obtained directly from the company, making secondary purchases (i.e. transfers of shares from one shareholder to another) ineligible.
- Active Trade Requirement: The business must remain active and cannot operate as a passive investment holding company.
Why QSBS Matters for Startups and Investors
For startups, QSBS provides a powerful incentive to attract and retain investors. It rewards them for long-term commitment, aligning their interests with the company’s growth trajectory. For investors, the QSBS tax exclusion can significantly enhance returns, making investments in early-stage companies more attractive.
Qualified Small Business Stock offers tremendous tax benefits for startups and investors, but compliance with QSBS requirements is essential. Working with experienced lawyers like SPZ Legal can help you navigate the complexities of QSBS and maximize the tax savings available for both your team and its investors.
For questions about QSBS eligibility for your company, contact SPZ Legal to get started with tailored, experienced advice.