Qualified Small Business Stock Exemption (QSBS) is one of the powerful tax breaks for small business and startup founders, investors, and employees with equity. It can allow you to completely avoid taxes when selling appreciative assets (like your equity or business), if it’s QSBS eligible.
QSBS allows you to avoid taxes on up to $10 million in capital gains or 10x the investment you made in an eligible company. Let’s say you sell your company for $10 million. Without QSBS, you may pay up to $3.5 million in taxes. With QSBS, you may pay nothing in taxes.
Here’s how it works.
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What is QSBS?
Qualified small business stock (also known as Section 1202 stock) is stock that allows you to avoid a huge portion of (or in some cases, all) associated capital gains taxes that you would normally owe when you sell or trade the stock for a profit. In order to qualify, though, you would need to have held the shares for at least 5 years.
Who does QSBS affect?
- Small business owners
- Startup founders and employees with equity
- Startup or venture investors
How much can you save in taxes with QSBS?
QSBS allows you to avoid federal capital gains taxes on up to a maximum of $10 million, or 10x the investment you made in an eligible company. Any earnings above the limit are taxed as ordinary capital gains.
However, depending on when you acquired the qualifying stock, the percentage of your profits that can be excluded can range from 75% to 100%.
- If your QSB stock was acquired after September 27, 2010, you can exclude up to 100% of your profits (up to the limit of $10 million, or 10x your investment).
- If your QSB stock was acquired from February 18, 2009 to September 27, 2010, you can exclude up to 75% of your profits (up to the limit of $10 million, or 10x your investment). Also, 7% of the gain is subject to the alternative minimum tax.
- If your QSB stock was acquired from the date QSBS was introduced in 1993 to February 18, 2009, you can exclude up to 50% of your profits (up to the limit of $10 million, or 10x your investment). Also, 7% of the gain is subject to the alternative minimum tax.
What about state taxes?
So you received QSBS exemption. Now you’re wondering can I avoid state taxes?
Good news. You can avoid state taxes in 45 out of 50 states. The 5 states you still have to pay taxes on your QSBS eligible equity are
New Jersey also has some additional requirements that can make it difficult to qualify. In any other state, you can avoid both federal and state taxes on your QSBS eligible equity.
In order to be eligible for QSBS exemption, there are certain requirements that must be met by both the small business you own or are investing in, and for the shareholders in that small business.
5 requirements for small businesses
All of the requirements below must be met by the small business in order to be considered a QSBS qualified company.
- Original Issue Requirement: Taxpayer must have received stock at the original issue of the company in exchange for money, other property, or services. In other words, you must have received the shares directly from the company (ex. purchasing shares from an employee doesn’t count). Most equity grants to founders, employees, and investors will qualify.
- US-based Domestic C Corporations Only: The company must be a US-based Domestic C-corp at the time of stock issue, at time of taxpayers sale or exchange, and all of taxpayers holding period. Virtually all U.S. based startups are C Corps when they take their first venture funding. S corporations are not eligible.
- Active Business Requirement: During taxpayers holding period, the issuing company must be active in a qualified trade or business. Holding companies do not qualify.
- Prohibited Industries: Most professional service industries, such as finance, investment management, and hospitality (like hotels and restaurants) don’t qualify. Tech startups almost always qualify.
- Small Business Requirement: At all times, before and immediately after issuance of stock, corporations adjusted basis in cash and other assets CAN’T exceed $50 million. In other words, you would have to have received your equity before the company has $50 million in net assets. You don’t need to exercise your options before then, you just need to have received it. This requirement is the most complex.
4 requirements for shareholders
All of the requirements below must be true for the shareholders in the business in order to be eligible for QSBS exemption.
- 5 Year Holding Period: The stock must be held for at least 5 years before the sale or exchange. The clock starts when the stock was exercised, not granted.
- Cannot be a corporation: Corporations are not eligible. You must be an individual, trust, or pass-through entity in order to qualify for exemption.
- Stock only: The shareholder must hold stock in the company. Bonds, options, or other types of assets like warrants and convertible assets are not eligible.
- Limits: As mentioned earlier, a shareholder can exclude up to $10 million in gains, or up to 10x the adjusted cost basis of your investment – whichever is greater.
Let’s pretend that Sarah starts a tech company called Mapple. She launches with a small investment of $100,000 and works tirelessly over the years to grow it into a successful business.
Fast forward five years, and Mapple has grown beyond her expectations. Sarah’s initial investment of $100,000 has ballooned into a substantial sum, with the company’s valuation reaching $10 million. She decides it’s time to sell her shares and move on to new opportunities.
Taxes owed without QSBS
If Sarah were to sell her shares without QSBS, she would owe capital gains taxes on her profits. Her capital gains would be calculated as the difference between the selling price and her initial investment. In this case, it would be:
Capital Gains = Selling Price – Initial Investment
Capital Gains = $10,000,000 – $100,000
Capital Gains = $9,900,000
Assuming a long-term capital gains tax rate of 20%, Sarah would owe:
Tax Owed = Capital Gains x Tax Rate
Tax Owed = $9,900,000 x 0.20
Tax Owed = $1,980,000
Taxes saved with QSBS
Now, let’s see how QSBS can significantly reduce Sarah’s tax liability. Since she meets all the QSBS requirements, she can potentially exclude 100% of her capital gains from taxation, up to the QSBS limit up to $10 million.
Sarah’s capital gains of $9,900,000 are below the QSBS limit, so she can exclude the entire amount from taxation. This means she saves the entire $1,980,000 that she would have paid in taxes without QSBS.
Total Tax Savings = Tax Owed Without QSBS – Tax Owed With QSBS
Total Tax Savings = $1,980,000 – $0
Total Tax Savings = $1,980,000
In this example, Sarah’s strategic use of QSBS allows her to save a staggering $1,980,000 in taxes when selling her shares of Mapple, and it underscores the power of QSBS in rewarding entrepreneurs and investors for their contributions to small business growth and innovation.
The QSBS limit of $10 million, or 10x your investment cost bases is the limit per individual. The “per individual” is the key piece here.
If you have more than $10 million in assets that you want to sell that is QSBS eligible, you can take advantage of the “per individual” limit by gifting up to $10 million to a loved one (like your child), and they can claim their own exemption, allowing you to essentially stack your QSBS exemptions.
You can also gift it to a trust that you or your children can benefit from in the future. There are specific kinds of trusts that, through the US tax code, qualify as individuals. Once gifted to the the trust, it could then receive its own QSBS exemption.
Going back to the example above, what if Sarah’s shares were actually worth $30 million rather than $10 million?
- Without QSBS stacking, she would claim QSBS exemption on $10 million of the $30 million, and then be required to pay capital gains taxes on the remaining $20 million.
- With QSBS stacking, she could gift $10 million to her daughter and $10 million to her son by setting each child up with a non-grantor trust and naming them as the beneficiaries. When the trusts sell the shares, they can each claim their own QSBS exemption and Sarah’s family will pay zero taxes on the entire $30 million sale of her shares in Mapple.
Do gifted shares need to be held for an additional 5 years?
Remember that one of the requirements for QSBS eligibility is that shareholders must have held the stock for at least 5 years. Fortunately, this transfers over with gifted stock. If you give qualifying shares to a loved one or trust, the holding period carries over. If the stock was eligible for QSBS when you gifted it, it remains eligible when they receive it.
QSBS for employees
Most people talk about QSBS in reference to business founders and investors. But it’s also important for startup employees with equity in the company they work for!
The same rules and benefits apply: QSBS allows employees to pay no federal (and sometimes state) taxes on up to $10 million when the company sells.
A few important points to remember:
- Ask your startup’s CFO if the company’s stock qualifies for QSBS. Most startups that have raised less than $50 million count, but not always. This shouldn’t be the most important factor in deciding where to work, but it’s not nothing because of how big the tax impact can be.
- The most important requirement to be eligible for QSBS is holding the stock for at least 5 years. You need to be holding the actual shares, not stock options. If you join the company early enough, ask if you can be issued restricted shares. If not, ask about early exercise. Exercising your options can be a tricky decision if it costs real money to exercise, but it’s a no-brainer if you’re early and the strike price is near $0.
What if the company sells before I held the stock for 5 years?
If the company sells and you haven’t held the stock for 5 years, you can either cash out and pay capital gains taxes, or, if you’ve held the shares for at least 6 months, you have the option to do a Section 1045 and do a QSBS rollover. Essentially, you can invest the money into another QSBS eligible company and resume the QSBS clock.
For example, if you held your shares for 2 years and your company sells, you could take the funds and invest it into another qualifying startup. Since you have 3 years left on your QSBS clock, you would only need to wait an additional 3 years before you can sell those shares and pay zero taxes on up to $10 million.
If you have over $10 million in gains, employees are also eligible to do QSBS stacking.
Learn about more tax hacks for business owners in our free guide: