Qualified Small Business Stock (QSBS): What Is It and Why Does It Matter?

In the US, the total capital gains tax can go as high as 50.3% in states such as California. This can significantly erode the earnings of investors and discourage investments into small businesses despite potential multifold returns.

To counter this trend, qualified small business stock (QSBS) tax benefits were introduced. Under Section 1202, you can potentially exclude gains of up to $10 million or 10 times the QSBS investment basis, whichever is greater. However, you must comply with several requirements to qualify for these tax benefits.

This article will explore the key qualifying conditions for QSBS, how investors can maximize gains through these provisions, and how businesses attain qualified small business (QSB) status.

What is Qualified Small Business Stock (QSBS)?

Under Section 1202, QSBS allows investors to exclude 100% of their gains up to $10 million or 10 times the investment basis, whichever is greater. To qualify for these benefits, the investors must hold their QSBS investments for at least 5 years.

A key requirement to become a qualified small business (QSB) is having a gross asset value of less than $50 million before and immediately after the QSBS issuance. Also, you cannot buy QSBS from a shareholder and get the tax benefits. These shares must be issued to you in exchange for money, service, or property other than shares for you to qualify for the abovementioned tax benefits.

How Does a Business Qualify for QSBS Treatment?

A business must meet certain key requirements about asset value and use, industry of operation, and corporate structure to qualify for QSBS treatment. These requirements are listed below:

Asset-related requirements

A business’s gross assets must be less than $50 million (before and immediately after investment) to qualify for QSBS treatment. Furthermore, 80% of these assets must be actively engaged in a qualified trade or business, i.e., in an industry not explicitly disqualified under Section 1202.

Disqualified industries

A business that does not operate in the following industries can qualify for QSBS treatment:

• Professional services such as actuarial science, consulting, and law
• Athletics and performing arts
• Banking, financing, insurance, and other related industries
• Agriculture
• Businesses involved in extracting products for which deductions are allowed
• under Section 613 or Section 613A
• Hospitality
• Businesses whose principal asset is the skill of one or more employees

Eligible corporation

Under Section 1202, an eligible corporation is defined as one that meets all of the following requirements:

• A domestic C-corporation
• Not a domestic international sales corporation (DISC)
• Not a regulated investment company
• Not a real estate investment trust (REIT)
• Not a real estate mortgage investment conduit (REMIC)
• Not a cooperative

Securities holding-related requirement

Any period in which your company’s holdings of stock and securities of entities that are not the business’s subsidiaries exceeded 10% of its net assets will not count for the QSBS holding period requirement.

Suppose that an investor has held their QSBS investment for 5 years, but for 2 years, your company held stocks and securities of non-subsidiaries that exceeded 10% of net assets. Then, to qualify for QSBS treatment, the investor must hold their investment for another 2 years.

Real estate holding-related requirement

The period during which the value of your company’s real estate engaging in disqualified businesses and trades exceeds 10% of the total assets is not counted towards meeting the QSBS holding period requirement.

Suppose one of your investors has held their QSBS investment for 5 years. In this period, the value of your real estate holdings engaged in non-qualified businesses and trades exceeded 10% of total assets for 7 months. Then, the investor must hold their investment for at least 7 more months to qualify for the QSBS treatment.

Strategies for Maximizing QSBS Benefits

To maximize your gains from QSBS treatment, you must apply the following strategies.

Entity Formation Strategies

As an entrepreneur, if you wish to attract funding by offering access to QSBS tax benefits, you must establish your company as a domestic C-corporation. You must note that various types of real estate investment and international investment companies cannot qualify for QSBS treatment.

Investment Timing and Structure

As an investor, you must insist on fresh issues in exchange for money, services, and property other than stocks to qualify for QSBS treatment.

Operational Strategies

Over the course of your operations, you must abide by the following two rules:

• Holdings of stocks and securities of non-subsidiaries should not exceed 10% of net assets
• Real estate holdings engaged in disqualified businesses and trades should not exceed 10% of total assets

Any period in which either of these rules is broken will not count towards meeting the QSBS holding period requirement of 5 years.

Exit Planning Strategies

The earliest possible exit that qualifies for QSBS tax benefits would be 5 years after the date of investment. However, you must adjust these dates whenever the requirements relating to stocks and securities of non-subsidiaries and the use of real estate holdings are not met.

Recent Advanced Strategies

Under Section 1045, QSBS investments can be rolled over. Suppose you sold your QSBS investment after just 6 months. By reinvesting these proceeds into another QSBS investment within 60 days, you can preserve the original holding period. This would also defer taxation of your gains from the original investment. So, if your original investment period was 6 months, you must hold your new QSBS investment for another 4.5 years to meet the 5-year holding requirement.

To avail this benefit, you must indicate an election of the QSBS rollover treatment on your tax returns.

Investment Basis	Max Exclusion	Tax Savings (50.3%)
$1M	$10M	$5.03M
$500K	$5M	$2.52M
$2M	$10M	$5.03M

What Is the QSBS Filing Process?

As an investor, to avail QSBS tax benefits, you must file Form 8949, Schedule D, and Form 1045, as well as the following forms, depending on the circumstances:

• Form 1099-B –  Sale facilitated by broker
• Form 1099-CAP – Receipt of cash, stocks, or other property due to a change in control or capital structure
• Schedule K-1 – QSBS received through partnership or S-corporation
• Form 6251 – Determining alternative minimum tax (AMT) if original investment date was before 27th September 2010
• Form 8960 – Declaration of portion of gain not eligible for QSBS treatment as part of net investment income

Furthermore, you must ensure that your portfolio companies get a QSBS attestation from a trusted valuation expert such as Eqvista.

Disqualification Triggers of QSBS

You may not qualify for QSBS tax benefits in the following circumstances.

Exceeding the $50 Million Asset Threshold

When you invest in a business with the intention of availing QSBS tax treatment, you must ensure that the business’s gross asset value does not exceed $50 million before and immediately after the investment is made. Otherwise, it would result in automatic disqualification.

Business Model Changes

QSBS tax benefits are available only for companies whose 80% of assets are actively engaged in qualified businesses and trades.

Improper Share Repurchases

Shares might lose their QSBS status if they were issued up to one year before repurchases exceeding a certain threshold or up to one year after such an event. This threshold is calculated as 5% of the aggregate value of all stock at the beginning of this 2-year period.

Furthermore, in the 4-year period starting 2 years before the issuance date, if the company redeemed stock from the investor or related persons, these stocks would not qualify as QSBS.

Improper Asset Management

As a founder, you must ensure that your real estate holdings engaged in non-qualified businesses and trade do not exceed 10% of total assets. Furthermore, you must also be careful not to hold stocks and securities of non-subsidiaries exceeding 10% of your net assets.

FAQs

Some common queries about QSBS are as follows:

What qualifies as QSBS?

Shares may qualify as QSBS if they were directly issued in exchange for money, services, and property other than shares by domestic C-corporations with gross assets of $50 million, 80% of which are engaged in qualified businesses.

What is the redemption rule for QSBS?

Redemptions exceeding a certain threshold or redemptions of stocks owned by the QSBS investor or related persons might result in disqualifications.

How do I claim QSBS?

To claim QSBS tax benefits, you may need to file Form 8949, Schedule D, Form 1045, Form 1099-B, Form 1099-CAP, Schedule K-1, Form 6251, and Form 8960.

What is the 10 times basis for QSBS?

QSBS treatment allows for exclusion of gains up to $10 million or 10 times the investment basis, whichever is greater.

What Tax Benefits Does QSBS Provide?

QSBS held for at least 5 years allows investors to exclude 100% of their gains up to $10 million or 10 times the investment basis, whichever is greater.

How Can Founders Set Up Their Business for QSBS Benefits?

You must establish your business as a domestic C-corporation and be mindful of the asset value and use requirement, regarding holdings of stocks and securities. You must also abide by the real estate holding use requirements.

How Can Investors Leverage QSBS in Their Investment Strategy?

Investors can leverage QSBS strategy when they are seeking investment opportunities in early-stage startups. However,they are high risk, investors must also diversify with less risky assets .

Eqvista – Unlocking tax savings through accuracy!

Meeting asset value and use requirements is the crux to unlocking QSBS tax benefits. Eqvista can help you surpass these hurdles through accurate QSBS attestations.

We can also help investors validate that the requirements regarding stocks and securities of non-subsidiaries and real estate use were met during the investment period. Contact us to learn more about our services!