QSBS Tax Benefits: How to Use Qualified Small-Business Stock

Small businesses are the heart of the American economy, employing nearly half of the country's workforce, according to the U.S. Chamber of Commerce^[0]

Although many don’t succeed, if you’re able to invest in a small business that does — especially a company that falls under the qualified small-business tax exemption — the potential returns and tax benefits could make the risk worth taking.

What is qualified small-business stock (QSBS)?

Qualified small-business stock, also known as Section 1202 stock, permits shareholders of certain qualified small businesses to exclude a significant portion of associated capital gains when selling or exchanging that stock if shares are held for over five years. Depending on the circumstances, you could potentially write off half to all of the federal income tax owed on gains from your gross income. QSBS is typically owned by investors and employees or founders of small businesses.

Here’s an example: Say you discovered a startup with a business concept likely to disrupt and revolutionize its industry. You invest $2 million into the business and receive the corresponding shares in 2018. The business takes off and you’re able to liquidate your shares for $15 million in 2024. Because the shares of this company qualify under the QSBS exemption, you’re able to pocket the $13 million capital gain without paying any taxes.

The qualified small-business stock exemption came about as part of the Revenue Reconciliation Act of 1993 to promote continued investment into small businesses and startup ventures, because they form a critical component of the economy.

There are two main requirements for qualified small-business stock: The business you invest in must be qualified, and you must meet shareholder criteria to reap the tax benefits.

» Find out other ways to reduce capital gains taxes

Which small businesses qualify for the QSBS exemption?

To take advantage of the QSBS exemption, you must invest in a qualified company, which means:

• The business must be an active domestic C-corp. The company must be incorporated in the U.S. as a C corporation; S corporations are not permitted. The corporation also must be actively engaged in business operations as opposed to a holding company.

• The company’s assets must not surpass $50 million, both before and after the issuance of stock.

• The business must not involve prohibited industries. Prohibited industries are personal services; banking, financing, insurance, investing or leasing; farming; mining; and running a hotel, motel or restaurant. Examples of industries that generally qualify include technology, wholesale or retail and manufacturing.

• The business must issue the stock directly. Known as the original issuance rule, the stock must be acquired directly from the issuer either in exchange for cash or property or as compensation. Employee benefits such as restricted stock units (RSUs), options and convertible securities are allowed, but acquiring stock from another person or through the secondary markets is not.

Note: As part of wealth transfer and charitable giving, the IRS provides an exception that enables QSBS to be gifted, subject to certain rules.

The active business test

Small-business founders and employees will want to pay careful attention to an additional rule — the active business test. This requires that at least 80% of the assets of the corporation (by value) are used in the conduct of one or more qualified trades or businesses.

"The 80% can include working capital, investments expected to finance research and experimentation or increased working capital within two years," says Mark Luscombe, principal federal tax analyst at Wolters Kluwer, a global information and software services company. "After the corporation exists for two years, no more than half of its assets can be working capital or investments held for future research or working capital."

Businesses that want to take advantage of the exemption also need to be cautious about where they invest or save that capital and the other 20% of assets.

"Portfolio securities, which are stocks in a non-subsidiary corporation that are not investments held for future research or working capital, cause the corporation to fail the active business test for any period during which they constitute more than 10% of its net worth," explains Luscombe. "It might be best, therefore, to avoid volatile securities that might increase quickly in value."

Instead, small businesses with cash to save or invest often take advantage of short-term, high-yield government debt options like Treasury bills and Treasury accounts, especially following the bank failures in 2023.

What are the shareholder requirements for QSBS?

• You cannot be a corporation. Only individuals, trusts or pass-through entities can benefit from the qualified small-business stock exemption.

• You must satisfy a holding period. Stocks acquired after Sept. 27, 2010, may qualify for a 100% federal tax exclusion if held for over five years. Stocks held over a year but less than five years are subject to long-term capital gains taxes, and stocks held less than a year are subject to short-term capital gains taxes. For stocks acquired on or before Feb. 17, 2009, and held for over five years, the maximum capital gains exclusion is 50%. For stocks acquired from Feb. 18, 2009, to Sept. 27, 2010, and held for over five years, the maximum capital gains exclusion is 75%.

• There is a maximum gain cap. A shareholder can exclude any gain up to the greater of 10 times the adjusted cost basis — which is the original asset value of the investment — or $10 million.

• You may be able to defer your gain. Shareholders wanting to sell stock prior to holding it for five years can still receive tax benefits as long as the original qualified small-business stock was held for longer than six months and all proceeds are reinvested into another QSBS within 60 days.

» Learn more about tax-efficient investing

Benefits of using the QSBS exemption

The earlier example illustrates the rewards shareholders can potentially reap when using qualified small-business stock — that investor walked away with a $13 million gain tax-free. Being able to offer such large tax incentives means that qualifying corporations can attract investors and leverage stock as employee benefits to recruit and retain talent.

For small businesses hoping to drum up additional funding, issuing QSBS can appeal to individual investors and encourage investors to become longer-term shareholders.

For small businesses in a growth phase, often cash can be scarce. Using stock options and RSUs as part of employee compensation packages can lure key talent and act as motivation for employees to take ownership.

» Want to invest in startups? Consider angel investing

Caveats to keep in mind with QSBS

Beyond dotting your i's and crossing your t’s with the requirements outlined above, there can be situations that muddy the waters with QSBS. For instance, qualifying small businesses should be vigilant when it comes to redeeming shares (when the company forces shareholders to sell stock back to the company). Too many redemptions could invalidate the remaining stock from QSBS eligibility.

"There is always the risk to investors that the corporation will cease to qualify as a QSBS due to a violation of one of the rules," says Luscombe. "It is also somewhat burdensome to constantly monitor to make sure the QSBS rules are not violated."