What is qualified small business stock (QSBS)?

Qualified Small Business Stock (QSBS) refers to stock that qualifies for tax benefits under Section 1202 of the U.S. Internal Revenue Code. This section allows the seller of QSBS to exclude up to 100% of capital gain on the shares from federal income tax. As of May 2024, any QSBS acquired after September 27, 2010, is eligible for this 100% exclusion. The exclusion is subject to limits of either $10 million or ten times the taxpayer’s adjusted basis in the QSBS, whichever is greater.

To qualify as QSBS:

1. The stock must have been originally issued by a domestic C-corporation. The corporation’s gross assets must be $50 million or less at the time of and immediately following the stock issuance.
2. The taxpayer must have acquired the stock at its original issue in exchange for money, property (excluding stock), or as compensation for services provided to the corporation.
3. While the taxpayer owns the stock, at least 80% of the corporation’s assets (by value) must be used in the active conduct of one or more qualified trades or businesses defined in the Internal Revenue Code, which excludes most professional services.
4. The corporation must qualify as an “eligible corporation” as defined in the Internal Revenue Code.
5. With some exceptions, the corporation must not have conducted significant redemptions of its own stock for one year before and one year after issuing the stock to the taxpayer, and must not have redeemed stock from the taxpayer for two years before and two years after issuing the stock to the taxpayer.
6. The taxpayer must not be a corporation.
7. The taxpayer must hold the stock for a minimum of five years.

The benefits of QSBS can be substantial, especially for long-term stockholders with significant capital gains. Founders, early employees and investors in startup companies are often able to avail themselves of QSBS. With proactive tax and estate planning, there may be an opportunity for taxpayers to “stack” QSBS benefits. However, certain actions by a company, like poorly timed stock redemptions, can result in the loss of QSBS treatment. Therefore, it is crucial to involve tax and legal professionals to properly structure transactions and avoid the unintended loss of QSBS benefits.