Qualified small business stock (QSBS) gives investors the opportunity to gain capital while paying zero tax on the stock they sell. It also offers better opportunities for small businesses seeking investment, offering greater incentives for investors to buy in.
Not all small businesses are eligible to offer QSBS, and not all holders of QSBS are eligible for a complete tax reduction – so it’s important to understand how qualified small business stock works to ensure you’re making the most of it.
What is a qualified small business stock?
Qualified small business stock (QSBS) is shares of a qualified small business, verified by the Internal Revenue Code (IRC). Investors of qualified small business stock are entitled to tax breaks, should the business and investor meet particular requirements.
Qualified small business stock refers to any stock issued by a qualified small business after August 10, 1993.
What is a qualified small business?
In order to invest in a small business and enjoy the tax benefits, that business must be considered a qualified small business (QSB) under the Internal Revenue Code (IRC). Being a QSB simply means being an active domestic C corporation with assets that don’t exceed $50 million upon the issuance of stock, however, only certain industries are eligible to obtain QSB status. Sectors where a business can be a QSB include retail, manufacturing and technology, while sectors that cannot be QSBs include agriculture, law, hospitality, and finance.
There are a number of conditions that must be met in order to enjoy the tax benefits of qualified small business stock.
The investor must be an individual, not a corporation. Their stock must have been purchased at its original issue rather than from a secondary market. The stock needs to be purchased with cash or property, or accepted as compensation for a service you offer. Investors can only benefit from tax breaks if they’ve held their qualified small business stock for a minimum of five years. On the business’s end, the QSB must use at least 80% of its assets on operations.
Benefits of qualified small business stock for business owners
Offering qualified small business stock is a great way for small businesses to gain the capital they need to expand their operations. This is because investors will be attracted to the tax benefits of QSBS, reducing the risk of investing in an emerging business. Furthermore, QSBS can be offered as payment-in-kind for services, allowing you to expand your resources even if cash flow is low. Small business owners can even offer QSBS as compensation to their employees, which could be a good employee retention strategy in the early stages of your company’s growth.
Tax breaks for qualified small business stock
The tax break you can receive from qualified small business stock differs depending on when the investment was made and how long the stock has been held. The Protecting Americans from Tax Hikes Act of 2015 lets investors in QSBS exclude 100% of capital gains taxes on the stock. There is a cap on the exclusion of either $10 million or 10 times the adjusted basis of the stock. If gains exceed either of those amounts, investors must still pay 28% of capital gains tax.
The 100% exclusion is available to those who acquired QSBS after September 27, 2010. If the QSBS was acquired between February 18, 2009 and September 27, 2010, you are able to get a 75% capital gains exclusion, with 7% of the excluded gain being subject to alternative minimum taxes (AMT). Any QSBS acquired between August 11, 1993 and February 17, 2009 is eligible for a 50% capital gains exclusion, with 7% of the exclusion subject to AMT.
Selling qualified small business stock early
Stockholders who sell their QSBS within five years of acquiring it are unable to receive a full capital gains tax exemption, but are still able to benefit. Under Section 1045 of the Internal Revenue Code, an investor selling their stock before the five-year holding period is over is able to defer the gain by reinvesting what they earned from the sale into another qualified small business, within 60 days of the sale.
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