Qualified Small Business Stock (QSBS)

What is a Qualified Small Business Stock?

Qualified small business stock (QSBS) refers to shares of a qualified small business (QSB) as defined by the Internal Revenue Code (IRC). A QSB is an active domestic C corporation whose gross assets—valued at the original cost—do not exceed $50 million on and immediately after its stock issuance.1

Eligible individuals meeting certain criteria are able to receive tax benefits if they hold qualified small business stock (QSBS)

IRC Section 1202 Qualified Small Business Stock (QSBS) 

  •  Current law (§1202) – A non-corporate taxpayer can potentially exclude up to 100% of the gain realized from the sale or exchange of QSBS held for more than five years

    • The greater of:

i. $10 million (lifetime limit) or

ii. 10 times the aggregate adjusted basis of QSBS issued by the corporation (annual limit)

  •      Per issuer limit

    • Married filing separately: $5 million

  • Exclusion from federal capital gains tax and 3.8% net investment income tax (§1411)

  • §1045 allows a taxpayer to potentially roll-over gain from the sale of QSBS that has been
    held for more than 6 months

    • Must purchase new QSBS within 60 days of sale

Requirements:

  1. Issued by a domestic corporation with < $50 million in assets at time of and immediately after issuance

  2. Issued by a corporation that uses at least 80% of its assets in active trade or business (other than personal services)

  3. Held by a non-corporate taxpayer (partnerships & S corps qualify)

  4. Acquired by taxpayer on original issuance

  5. Held for more than 5 years

Active Business Requirement

  • At least 80% (by value) of assets must be used by the corporation in the active conduct of one or more “qualified trades or businesses” . Exceptions:

  • Reasonable working capital needs

  • R&D expenses

  • Start-up expenses

  • 10% limit: portfolio securities

  • 10% maximum real estate holdings

“Original Issuance” Requirement

QSBS must generally be acquired at “original issue” (directly or through an underwriter) in exchange for:

  • Money

  • Property other than stock

OR

  • Compensation for services performed for such corporation

 

Qualifications:

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  • QSBS does not apply to equity interests in pass-through entities, such as S-corps or partnerships

  • Only C corp stock

  • QSBS held by a pass-through entity:

    • May potentially qualify for the §1202 exclusion

    • Must have held the interest on the date the entity acquired the QSBS

    • Must have held the interest all times thereafter until the stock was sold

Qualified Trade or Business

  • The following are not considered qualified trades or businesses:

    • Any trade or business involving the performance of services in the fields of health care, law, engineering, architecture, accounting, financial services etc.

    • Any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees

    • Banking, insurance, financing, leasing, investing or similar business

    • Farming business

    • Any business eligible to claim a deduction for depletion

    • Businesses of operating a hotel, motel, restaurant or similar business

  • Note: IRC §199A uses part of the language from above

QSBS Holding Period

  • The holding period begins on the date of issuance

  • The holding period also tacks on in the case of tax-free incorporation (under § 351) or a reorganization (under § 368)

    • Limitation: QSB stock treatment will be limited to the amount of gain accrued when rolled over into nonqualified small business stock unless the acquiring corporation is a qualified small business, in which case the stock issued is treated as entirely QSB stock

  • The holding period of QSBS acquired in a §1045 rollover transaction generally tacks on

  • QSBS held for less than 5 years when sold, still has the opportunity to rollover proceeds into new QSBS stock with tacked on holding period

  • Stock options, warrants, convertible debt:

    • Do not qualify as QSBS until exercised/converted

  • Acquisition date for stock-based compensation:

    • Incentive stock options: date of exercise

    • Restricted stock no §83(b) election: date of vesting

    • Restricted stock §83(b) election: date of election

• Recipient is considered to own the stock when they have an unrestricted right to the shares

• Holding period tacks for convertible preferred stock to common stock