Key takeaways
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Qualified Small Business Stock (QSBS) is a tax incentive that could potentially save entrepreneurs, startup founders, early startup employees, and investors a significant amount of money. In this comprehensive guide, we will go into the complete details of QSBS, from its eligibility requirements to its tax benefits, how QSBS works, and how you can make use of it in your own entrepreneurial or investment journey.
Table of Contents:
- What is QSBS?
- Tax Benefits of QSBS
- Eligibility Requirements for QSBS Benefits
- States Conforming with the QSBS Tax Exclusion
- How to Claim a QSBS Exclusion or Deferral
- QSBS and 83(b) Elections
- QSBS and Alternative Minimum Tax (AMT)
- Strategies for Planning a QSBS Investment
- Potential Risks and Pitfalls of QSBS
- Frequently Asked Questions
What is QSBS?
Qualified Small Business Stock refers to the shares of a Qualified Small Business (QSB) that meet specific requirements outlined by the Internal Revenue Code (IRC) Section 1202. Qualified Small Business Stock offers significant tax benefits to entrepreneurs, startup founders, early startup employees, and investors by providing either an exclusion from capital gains tax or a deferral of capital gains tax when a qualifying company’s shares are sold.
Tax Benefits of Qualified Small Business Stock
There are two primary tax benefits associated with Qualified Small Business Stock:
- Exclusion of Capital Gains: Generally, if you acquired QSBS shares after September 27, 2010, you can exclude up to 100% of the qualified capital gains. The amount of gain eligible for exclusion is capped at the greater of $10 million, or 10X the shareholder’s adjusted basis in the stock.
- Deferral of Capital Gains: Shareholders can defer capital gains tax on the sale of QSBS if they reinvest the proceeds into another QSBS within 60 days. The gain is deferred until the replacement stock is sold, and the original stock’s holding period is added to the holding period of the replacement stock.
Other tax benefits of QSBS include:
- Estate tax benefits: The value of QSBS shares is excluded from the taxable estate of the shareholder, subject to certain limitations. Because of this, QSBS shareholders can potentially reduce their overall estate tax liability by holding QSBS.
- No net investment income tax (NIIT): Proceeds from the sale of QSBS are not subject to the NIIT, which is an additional 3.8% tax on certain types of investment income.
Eligibility Requirements for QSBS Benefits
To take advantage of QSBS benefits, both the issuing corporation and the shareholder must meet specific requirements, which are outlined below.
Issuing Corporation Requirements
- Domestic C Corporation: The corporation must be a domestic C corporation.
- Gross Assets: The corporation’s aggregate gross assets must not exceed $50 million before and immediately after the stock issuance.
- Active Business Requirement: At least 80% of the corporation’s assets must be used in the active conduct of one or more qualified trades or businesses during substantially all of the shareholder’s holding period for the stock. This means that the corporation must be engaged in a trade or business, and not be a passive investment company.
Shareholder Requirements
- Exercise any options first: QSBS does not apply to stock options, meaning employees must first exercise any options and buy their company shares first in order to qualify for a QSBS Exclusion.
- Holding Period: The founder, employee, or investor must have held the QSBS for at least five years to fully benefit from the QSBS tax exemption. This holding period begins on the date of acquiring QSBS shares and ends on the date the QSBS is sold or exchanged.
- Original Issuance: The shareholder must have acquired the QSBS at its original issuance in exchange for money, property (other than stock), or as compensation for services provided to the corporation. This means that the QSBS must have been acquired directly from the issuing corporation, and not from another shareholder or in a secondary market transaction.
QSBS Attestation Letter
A QSBS attestation letter is a formal document typically provided by a company to certify that its stock meets the IRS criteria qualifying it as QSBS. The attestation letter usually includes details such as the company’s qualification as a small business, the nature of its business, and assurances that it meets the active business requirements and other criteria necessary for the stock to be considered QSBS.
It’s important to note that QSBS benefits are subject to certain limitations and exclusions, and not all QSBS will qualify for the full range of benefits. Additionally, QSBS benefits are subject to change based on changes in tax laws and regulations. As with any tax-related matter, it’s recommended that you seek professional advice from a tax advisor or another qualified tax professional to ensure that you understand the requirements and benefits of QSBS.
Which States Conform with QSBS in 2024?
It’s important to note that not every state adheres to the QSBS. State-specific rules and limitations regarding QSBS and other tax benefits can vary widely depending on where you live. Some provide state tax benefits similar to the federal tax benefits while other states only partially conform or don’t conform to QSBS at all. See the lists below to see where your state falls.
Non-conforming States:
Taxpayers in these states are not eligible for the state tax break, even if they qualify for the federal tax exemption:
- Alabama
- California
- Mississippi
- New Jersey
- Pennsylvania
- Puerto Rico
Partially Conforming States:
Some states have partially conformed with the QSBS Tax Exclusion, meaning they have their own rules and limitations regarding QSBS benefits. Depending on the state’s tax code, taxpayers in these states may be eligible for a partial state tax break. However, it’s important to note that the rules and limitations can vary widely from state to state. Here are the partially conforming states:
- New Jersey
- Massachusetts
How to Claim a QSBS Exclusion or Deferral
To claim the QSBS exclusion or deferral, shareholders need to follow these steps:
- Verify QSBS eligibility: Ensure that both the issuing corporation and the shareholder meet the QSBS eligibility requirements outlined in Section 2. This includes ensuring that the corporation is a domestic C corporation with aggregate gross assets of $50 million or less before and after the stock issuance and that it uses at least 80% of its assets in the active conduct of one or more qualified trades or businesses.
- Calculate the exclusion amount: Determine the amount of capital gains that can be excluded based on the 100% exclusion limit (up to $10 million or ten times the shareholder’s adjusted basis in the stock). This calculation can be complex and may require the assistance of a Harness Tax Advisor or another tax professional.
- Report the transaction on tax returns: Report the transaction on tax returns: Shareholders need to report the sale of QSBS on their federal income tax return (Form 1040, Schedule D). The exclusion is reported on Form 8949, while the deferral is reported on Form 6252. It is important to ensure that all required documentation and records are maintained to substantiate the QSBS status in case of an IRS audit.
QSBS and 83(b) Elections
An 83(b) Election is a tax strategy that allows startup founders and early employees to elect to be taxed on the fair market value of their restricted stock awards at the time of grant rather than at the time of vesting. This election can be particularly beneficial for those who anticipate a significant increase in the value of their stock over time, reducing their tax liabilities over the long term.
When it comes to QSBS, making an 83(b) election can help shareholders satisfy the five-year holding period requirement more quickly. By electing to be taxed at the time of the grant, the shareholder’s holding period starts from the grant date, rather than the vesting date.
QSBS and Alternative Minimum Tax (AMT)
Historically, QSBS benefits were subject to the Alternative Minimum Tax (AMT), limiting some taxpayers’ overall tax savings. However, the Tax Cuts and Jobs Act of 2017 (TCJA) eliminated the AMT for corporations and increased the AMT exemption amounts and phase-out thresholds for individual taxpayers. As a result, the impact of AMT on QSBS benefits has been significantly reduced.
Strategies for Planning a QSBS Investment
Before taking advantage of the QSBS tax benefits, consider the following strategies:
- Timing of investment: Investing in qualified small businesses as early as possible can maximize the potential capital gains exclusion. The longer the holding period, the greater the potential tax savings.
- Diversification: Spreading investments across multiple QSBs can maximize the aggregate exclusion limit. This can help reduce the risk of loss associated with investing in a single company.
- 83(b) elections: For startup founders and early employees, making an 83(b) election can accelerate the start of the holding period. This can help maximize the potential tax benefits of QSBS.
- Monitor QSB status: Continuously tracking the issuing corporation’s QSB status is crucial to ensure it remains eligible for QSBS tax benefits. If the corporation loses its QSB status, the stock may no longer qualify as QSBS, and the tax benefits could be lost.
- Plan for reinvestment: If planning to defer capital gains through reinvestment, it is important to identify potential replacement QSBS in advance to meet the 60-day reinvestment window. This can help ensure that investors maximize the potential tax benefits of QSBS.
Potential Risks and Pitfalls of QSBS
While QSBS offers significant tax benefits, it is essential to be aware of potential pitfalls and risks that may arise:
- Loss of QSBS status: If a corporation loses its QSB status, the stock may no longer qualify as QSBS, and the tax benefits could be lost.
- Incomplete documentation: To claim QSBS tax benefits, investors must be able to substantiate the QSBS status of the stock in case of an IRS audit. This requires maintaining accurate and complete documentation and records, including stock certificates, incorporation documents, financial statements, and tax returns.
- Complexity of tax laws: The tax code is subject to change, and it is essential to stay updated on any revisions or amendments that could impact QSBS eligibility and benefits. The eligibility requirements and tax implications associated with QSBS are complex and may vary depending on the specific circumstances of the investment.
- Investment risk: Investing in small businesses carries inherent risks, and there is no guarantee that a business will succeed or that its stock value will appreciate. QSBS tax benefits should not be the sole factor in making an investment decision.
Frequently Asked Questions
What states don’t recognize QSBS?
As of 2024, Alabama, California, Mississippi, New Jersey, Pennsylvania, and Puerto Rico do not offer state tax benefits for QSBS.
Can any company qualify as a Qualified Small Business (QSB) for QSBS benefits?
No, not all companies can qualify as a QSB and be eligible for QSBS benefits. The corporation must be a domestic C corporation and meet specific requirements outlined in the Internal Revenue Code (IRC) Section 1202. LLCs, partnerships, and S-corporations are not eligible.
How does QSBS work?
QSBS works by allowing shareholders to exclude up to 100% of the capital gains on the sale of QSBS, subject to certain limits. The exclusion is capped at the greater of $10 million or 10X the shareholder’s adjusted basis in the stock. To claim QSBS benefits on their tax returns, shareholders need to ensure that both the issuing corporation and the shareholder meet the QSBS eligibility requirements. They must then calculate the exclusion amount, report the transaction on their tax returns, and maintain all required documentation and records to substantiate the QSBS status in case of an IRS audit.
Can QSBS benefits be applied to stock options?
No, QSBS benefits do not apply to stock options like ISOs or NSOs. Employees must first exercise their options and buy their company’s shares before their shares can become QSBS-eligible.
Can QSBS benefits be applied to investments in non-US companies?
No, QSBS benefits on federal taxes only apply to investments in US-based C corporations that meet the specific requirements outlined in the Internal Revenue Code (IRC) Section 1202.
Can QSBS benefits be combined with other tax incentives or deductions?
Yes, QSBS benefits can be combined with other tax incentives or deductions, but it is important to consult with a Tax Advisor or other qualified tax professional to ensure that all requirements and limitations are met.
What happens if a corporation loses its QSB status after QSBS shares have been acquired?
If a corporation loses its QSB status, the stock acquired as QSBS may no longer qualify, leading to losing the QSBS tax treatment.
Harness Can Help Navigate QSBS
Understanding and taking advantage of QSBS tax benefits can be complex, and it’s important to have professional advice when making any major financial decision. Harness and its network of advisors are here to help. Tax advisors can help with determining QSBS eligibility and with tax preparation when you sell your QSBS, while a wealth manager on the Advisor Marketplace can help you invest proceeds QSBS you’ve sold, or help you source deals to rollover the proceeds into a new Qualified Small Business. With experience working directly with startup founders, early employees, and investors, and expertise in equity compensation and small business taxes, Harnesswill be there for you at every step of your investment journey. If you have QSBS or are considering investing in a small business or startup, sign up for Harness today.
Tax services provided through Harness Tax LLC. Harness Tax LLC is affiliated with Harness Wealth Advisers LLC, collectively referred to as “Harness Wealth”. Harness Wealth Advisers LLC is an internet investment adviser registered with the Securities and Exchange Commission (“SEC”). Harness Wealth Advisers LLC solely acts as a paid promoter for unaffiliated registered investment advisers. Harness Wealth Advisers LLC’s registration as an investment adviser with the SEC does not imply a certain level of skill or training.
This document does not constitute advice or a recommendation or offer to sell or a solicitation to deal in any security or financial product. It is provided for information purposes only. All investments have risks and have the potential for profit or loss. To the extent that the reader has any questions regarding the applicability of any specific issue discussed above to their specific portfolio or situation, the reader is encouraged to consult with the professional advisor of their choosing.
