Qualified Small Business Stock: Everything You Need to Know
Qualified Small Business Stock, or QSBS, is stock issued from a qualified small business, which must be a domestic C corporation. 5 min read
2. Tax Benefits of QSBS
3. How Can a Business Qualify for QSBS Treatment?
4. Frequently Asked Questions
What is a Qualified Small Business Stock?
Qualified Small Business Stock, or QSBS, is stock issued from a qualified small business, which must be a domestic C corporation. The stock must be sold after Aug. 10, 1993, in exchange for money, property, or services. QSBS is a tax windfall that is often overlooked by most taxpayers.
Tax Benefits of QSBS
If you are a stockholder of QSBS, such benefits can include:
- A portion of the gain on your QSBS over the five-year holding period can be excluded from federal tax. At times, up to the entire amount of the gain can be excluded.
- Any portion of the non-excluded gain is taxed at a 28 percent rate, as long as your tax bracket is between 15-20 percent.
- The excluded gains are also not subject to the 3.8 percent investment income tax.
- The maximum amount of gains that can be excluded from federal income tax is the greater of $10 million or 10 times the person’s adjusted basis in the stock itself.
- Congress has consistently increased the amount of gains that can be excluded to provide more incentives for small businesses wishing to provide QSBS to people.
How Can a Business Qualify for QSBS Treatment?
The following criteria must be met in order for a business to qualify for QSBS treatment:
- The company issuing the stock must operate a domestic C corporation.
- The corporation must operate in one of the following lines of business: law, accounting, financial services, health care, engineering, architecture, performing arts, actuarial science, athletics, brokerage services, or another similarly situated industry where the type of trade involved relates to the skill of one or more of the employees, i.e., a law firm hires only those with a legal background. Similarly, a health care company only hires those with a health care background. Excluded from qualification are banks, insurance leasing companies, investment companies, farming businesses, hotels/motels, and restaurants.
- Stock must be issued after Aug. 10, 1993.
- The stock must be purchased from the taxpayer directly from the company for money, property, or services.
- The tax basis of the corporation’s total gross assets must be less than $50 million at all times after Aug. 10, 1993, until immediately following the date of stock issuance. Should the assets exceed this amount, the corporation can no longer qualify for QSBS treatment, even if the assets are reduced below the threshold at a future date.
- The corporation cannot own real property that is not being used in the operations of the business nor can the corporation own portfolio stock or securities with a value exceeding 10 percent of the total assets of the company.
- Certain circumstance may change the company’s qualifications for QSBS treatment. Therefore, if any of the above conditions change at any given point in time, the stock may no longer be treated as QSBS.
Some things to keep in mind for those purchasing QSBS stock include:
- Document your purchase. You want to ensure that you keep all records in a private portfolio for each stock purchase. Be sure to include the date of purchase, price, a copy of the share certificate, and a copy of the wire transaction or check used to purchase the stock.
- Have your stock certified. Make sure your stock is certified immediately after purchasing it.
- Watch the clock. Be aware of the date when your investment reaches the 5-year holding period.
- Seek the help of a professional. If you’re investing in a lot of QSBS, you should hire an accountant who understands the nuts and bolts of the requirements and rules to follow.
Frequently Asked Questions
- What if I’m a partner or shareholder in the company that purchases QSBS stock?
If you are a partner or shareholder in the company that purchased the QSBS stock, you cannot exclude the gain received from the QSBS stock if such gain exceeds your interest in the entity at the time the entity purchased the QSBS stock.
- Why haven’t QSBS exclusions been used more in the past?
For QSBS purchased prior to Sept. 27, 2010, a gain exclusion applied in which a much lower percentage could be excluded from the gain thereby resulting in an unfavorable tax adjustment. As a result, taxpayers didn’t see much of a gain, if any, due to the 28 percent tax rate imposed on the portion of the QSBS gain that was included in one’s federal income.
- What if I’m a non-corporate partner?
Stock can be eligible as QSBS for non-corporate partners as long as a non-corporate partner was present in the partnership at the time the stock was purchased and at all times during the holding period. A non-corporate partner may also be eligible for a gain exclusion only if the gain is based on the partner’s percentage of interest in the partnership at the time it purchased the QSBS.
- What if the five-year holding period isn’t met?
A taxpayer who doesn’t meet the required holding period can defer some or all of the gains made when selling the stock by simply reinvesting the funds in another QSBS. Therefore, for example, if you hold QSBS stock and wish to sell it after three years, any gains you made within those first three years can be deferred for tax purposes so long as you reinvest the sale proceeds in another QSBS.
Keep in mind that the taxpayer must have held the stock for a period of at least six months and reinvest the proceeds of the sale within 60 days after the date of such sale.
- Are there any downsides to owning QSBS?
You should keep in mind that not all states, including California, follow the federal income tax treatment of QSBS; therefore, you may still owe additional state income tax should you carry QSBS in a state that doesn’t follow the federal treatment. Further, should a corporation no longer be categorized as a qualified small business, the QSBS stock may be affected due to such inabilities to qualify.
There are many requirements and considerations to factor in when deciding whether or not you should purchase QSBS or, alternatively, if you are a qualified small business wishing to sell your stock to taxpayers. If you want need additional help with QSBS, you can post your legal need on UpCounsel’s marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.