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.

QSBS offers several tax benefits to investors in early-stage startups and small businesses, allowing them to exclude all capital gains on their investments. This article explains what QSBS is, how businesses and investors can qualify for these benefits, and strategies to maximize gains while avoiding pitfalls.

Key Takeaways

• Ensure accurate and timely QSBS attestations from trusted valuation experts to support your claims.
• Regularly review your company’s asset composition to maintain QSBS tax eligibility.
• Consult tax professionals to integrate QSBS strategies with your overall investment or business exit plan.

What is Qualified Small Business Stock (QSBS)?

Qualified Small Business stock(QSBS) is a special tax provision under Internal Revenue Code under section 1202. It provides a powerful tax exclusion benefit to investors from paying capital gains up to 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.

To qualify, the stock must be issued directly by a domestic C-corporation meeting specific asset, business activity, and holding requirements.

QSBS Eligibility Requirements

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:

• To qualify for QSBS eligibility, your company must meet specific asset and operational requirements outlined under Section 1202.
• Maintaining QSBS eligibility requires that the business remain a domestic C-corporation and avoid disqualified industries.
• Investors should understand that QSBS eligibility depends on holding the stock for at least five years to maximize the tax benefits.
• Certain business activities or stock repurchases may cause a loss of QSBS eligibility, so careful planning is essential.
• QSBS eligibility is foundational to accessing the significant capital gains tax exclusion provided by this provision.
• Founders must regularly assess their company’s operations and financial structure to ensure continued QSBS eligibility.

For founders, QSBS is a game of foresight. The diligent paperwork you complete in your earliest, leanest days is what ultimately secures your multi-million dollar tax exemption years down the line. – Brayton Johnson, COO & Head of Revenue, Eqvista

QSBS Asset-related Eligibility requirements

• A business’s gross assets must be less than $50 million (before and immediately after investment) to qualify for QSBS treatment.
• At least 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.

Securities holding-related requirement

To maintain QSBS status, a company must:

• Limit its holdings of stock and securities of non-subsidiary entities to less than 10% of its net assets.
• Limit real estate holdings in disqualified businesses or trades to under 10% of total assets.

Any time these thresholds are exceeded does not count toward the required five-year holding period.

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

Strategies for Maximizing QSBS Tax Benefits

To qualify for the QSBS tax exclusion, investors must acquire stock directly from the company and hold it for the required five-year period, ensuring they maximize the tax advantages available. The core advantage of QSBS lies in its ability to reduce or eliminate the capital gains tax liability on profits from the sale of stock, as long as investors meet the holding period and other qualifying criteria. To maximize your gains from QSBS treatment, founders and investors must apply the following strategies.

QSBS Strategies For Founders

Start as a C-Corporation from day one to avoid resetting QSBS eligibility. Issue founder shares at formation when valuation is lowest and file 83(b) elections immediately. Monitor gross assets carefully to stay under $50 million by timing fundraising strategically and using debt financing when approaching limits. Structure employee equity as restricted stock grants rather than options and ensure all recipients file timely 83(b) elections.

Maintain qualifying business activities by keeping 80% of assets in active business use and avoiding excluded services like consulting or hospitality. Consider issuing shares to family members to multiply the $10 million exclusion per person. Plan exits carefully around the 5-year holding period and structure partial liquidity events to preserve QSBS on remaining shares.

QSBS Strategies for Investors

Focus exclusively on primary market investments in original company issuances, never secondary purchases. Target seed and early-stage rounds when valuations are lower for maximum appreciation potential. 

Verify each company’s QSBS qualification including C-Corp structure, sub-$50 million assets, and qualifying business activities.

Build a diversified portfolio of multiple qualifying companies since each provides a separate $10 million exclusion opportunity. Track holding periods precisely for the mandatory 5-year minimum. Consider family member investments to multiply benefits and use Section 1045 rollovers to defer gains while reinvesting in new QSBS opportunities. Avoid investing through partnerships or funds since QSBS benefits typically don’t pass through these structures.

The earliest exit eligible for the QSBS tax exclusion occurs after the five-year holding period; however, adjustments may be necessary if asset or holding period requirements are not met.

Example: Potential Tax Savings With QSBS

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?

To claim QSBS benefits, investors must accurately report their capital gains on the relevant tax filings and demonstrate eligibility for the exclusion to minimize or defer capital gains tax.

Claiming the QSBS tax exclusion Investors must file:

• IRS Form 8949 and Schedule D for capital gains reporting
• Form 1045 to elect deferrals or rollovers if applicable
• Additional forms based on circumstances: Form 1099-B, Form 1099-CAP, Schedule K-1, Form 6251 (for Alternative Minimum Tax), and Form 8960 (Net Investment Income Tax)

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

Think of the QSBS tax exemption as a locked treasure chest. The attestation is the key. Our job is to hand that key to founders to unlock their millions. Shivank Agarwal, Senior Associate – Valuation and Advisory, Eqvista

Disqualification Triggers of QSBS

Failure to meet QSBS requirements may lead to disqualification, exposing investors to full capital gains tax on the accrued profits from their stock sales. 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.

Summary Table of Common QSBS Disqualification Triggers

Disqualification Trigger	Key Details
Asset Threshold	Exceeding $50M (or $75M after 7/4/2025) at issuance or immediately after
Business Qualification	Less than 80% of assets in qualified trades or businesses
Share Redemptions	Significant redemptions within one year before/after issuance (≥5% for general, ≥2% for related parties)
Excess Securities/Real Estate Holdings	Over 10% in non-subsidiaries securities or non-qualified real estate
Share Transfers	Failure to meet QSBS conditions on secondary transfers

Careful planning around these triggers is essential to preserve QSBS eligibility and maximize tax benefits. Companies and investors should seek expert guidance to navigate these complex rules.

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 the 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.

Can QSBS be rolled over?

Yes, capital gains can be deferred by reinvesting proceeds into new QSBS within 60 days under Section 1045, preserving the original holding period.

How long must I hold QSBS to qualify?

At least five years, adjusted if holding period requirements are interrupted by disqualifying asset holdings.

What is the QSBS tax exclusion?

The QSBS tax exclusion allows investors to exclude from taxable income a substantial portion of the capital gains realized from the sale of qualified small business stock held for more than five years, subject to certain limits and requirements.

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!