QSBS (Qualified Small Business Stock) Overview
The Qualified Small Business Stock (“QSBS”) tax exclusion under Section 1202 of the Internal Revenue Code (“Section 1202”) may sound like something only your tax lawyer would understand. However, this article explains why it is perhaps one of the more powerful provisions in the tax code to enable founders, entrepeneurs and investors to significantly reduce or eliminate their federal income tax liability on the sale of their stock in their start-up or venture investments.
In general, Section 1202 allows noncorporate taxpayers to exclude from such taxpayer’s federal taxable income 100% of any gain realized on the sale or exchange of stock in a qualified small business held for more than five years. This exclusion applies to gains of up to $10 million or 10 times the basis of your initial investment, whichever is greater. Depending on when you acquired your QSBS (i.e., prior to September 28, 2010), the exclusion may be reduced to 50% or 75%.
At the highest level, if you bought stock in a corporation that qualifies as QSBS five years ago for $10 and sold it tomorrow for $100, you’ll owe the IRS up to 20% (depending on your income) of the $90 in taxable gain (which is the difference between your tax basis of $10 and the sale price of $100). However, if you qualify for the QSBS exclusion, you can exclude 100% of the gain and not pay any federal income tax whatsoever, and sleep tight knowing the full $100 bill is all yours (subject to state and local taxes).
Section 1202 outlines the requirements of the QSBS tax exclusion, which are as follows:
- The taxpayer must not be a corporation;
- The taxpayer must have held the stock for more than five years;
- The taxpayer must have acquired the stock directly from the issuer (with limited exceptions);
- The stock must have been issued to the taxpayer in exchange for money, property (not including stock) or as compensation for services;
- The issuer must qualify as a “Qualified Small business” (i.e., be a domestic C corporation, generally have gross assets not in excess of $50 million either on the date of the stock issuance or immediately after that date); and
- The issuer must satisfy the “Active Business” requirement (i.e., the issuer must use at least 80% of its assets in the active conduct or one or more qualified trades or businesses during substantially all of the investor’s holding period).
There are some additional technical rules that may apply, such as a disqualification of the exclusion if (i) the issuer engaged in certain types of redemptions from the taxpayer (and related persons) during the four-year period beginning on the date two years before the issuance, or (ii) if the issuing corporation redeems more than a de minimis amount of its stock from all investors during the two-year period beginning on the date one year before the stock issuance and the purchased stock has an aggregate value exceeding 5% of the value of all of the issuing corporation’s stock as of the beginning of that period.
In summary, qualifying for and maintaining a QSBS tax exclusion can be extremely beneficial to founders, entrepreneurs, and investors for the sheer amount of tax savings it could potentially present to those that know how to either apply the rules to their own investments, or more likely (and more importantly), hire the right legal and tax counsel to ensure proper compliance.
 You may also have to pay the separate net investment income tax at a rate of 3.8%.