What is Qualified Small Business Stock (QSBS)?

When a company’s shareholders sell their stock at a gain, they typically have to pay taxes on the amount they earned from selling the shares, which are known as capital gains taxes. Depending on how long you’ve held these shares at the time of sale, you’ll pay either short-term or long-term capital gains taxes, and the applicable rate will depend on your overall taxable income. For example, if you hold the shares for over a year and then sell them, the current top U.S. federal long-term capital gains tax would be approximately 20%.

While it’s nearly impossible for the average taxpayer to predict how tax laws may change (such as the recent changes arising from the OBBBA), you should review and understand existing tax regulations to optimize tax efficiencies and avoid any potential future penalties.

Tax rate hikes: Certain exemptions may become more valuable

Generally speaking, tax deductions or exemptions become more valuable as tax rates rise. If tax rates on federal long-term capital gains do increase in the future, one particular exemption that could become even more valuable is a long-term capital gains tax exemption for certain gains from the sale of qualified small business stock (QSBS) under Section 1202 of the Tax Code (i.e., the 1202 exemption). Unless otherwise indicated herein, this discussion describes the QSBS rules as in effect prior to the OBBBA.

Investors and potential new small business owners should carefully consider the QSBS rules that might apply to starting a new business, including whether stock issued by a new company could qualify as QSBS and if a future sale of the stock by shareholders could qualify for the Section 1202 exemption. But under law in effect prior to the OBBBA, in order for stock of a new company to qualify as QSBS – and potentially be eligible for the 1202 exemption at a later date (among other complex requirements that are applicable during the holding period) – it must meet the following stipulations:

For stock issued after the OBBBA date:

There are, however, important details worth noting about these requirements. To meet the first requirement, the stock cannot be stock of either a non-U.S. corporation or an S corporation (i.e., a flow-through entity through which the owners and/or shareholders are subject to U.S. federal income tax). For the second requirement, the shareholder is not allowed to have acquired the stock from a third party in a secondary sale but must have received it directly from the issuing company itself. As for a company’s gross assets for purposes of the asset requirement, this generally includes all assets of any company subsidiary that is at least 50% owned by the parent company, aggregating any subsidiary assets with the majority-holding parent company’s assets.

QSBS: Who qualifies and who doesn’t

For a shareholder to be a qualified shareholder, they cannot be a C corporation themselves, meaning they must be an individual. Similarly, only certain types of businesses count as a qualified business for the purpose of QSBS, while several types of businesses cannot. Business types that generally don’t meet the definition of qualified businesses include the following:

If your new company meets these QSBS requirements – and the Section 1202 exemption applies to the sale of the company’s shares by a qualified shareholder – under law as in effect prior to the OBBBA date, the maximum amount of gain that can generally be exempt under the Section 1202 exemption is the greater of $10 million (reduced by eligible gain taken in previous years) or 10 times the shareholder’s aggregate adjusted tax basis in the QSBS sold during the year. For stock issued after the OBBBA date, the maximum amount of gain that can generally be exempt under the Section 1202 exemption is the greater of $15 million (which is adjusted for inflation but will be reduced by eligible gain taken in previous years) or 10 times the shareholder’s aggregate adjusted tax basis in the QSBS sold during the year.

Considerations for business owners who want to prime their company for a QSBS exemption

If you’re forming a new company and are looking to qualify for the Section 1202 exemption, it’s wise to consult with a tax professional who can advise on carefully navigating the complex requirements for shares of a new C corporation to qualify as QSBS. Nevertheless, there are some things you can do to prime your new company to potentially qualify for these exemptions.

First, your company must be formed as a C corporation, or as a Limited Liability Company (LLC) that duly and timely files an election to be classified as a corporation for U.S. federal income tax purposes. As we mentioned earlier, certain types of business can’t qualify for the Section 1202 exemption, so the type of business you establish is key. Keep in mind, too, that it’s important to test whether your company is still meeting these requirements after it issues new shares, is maintaining them throughout the shareholder’s holding period and is meeting them at the time of the subsequent disposition of the shares. For example – and assuming all the requirements have been met – newly issued shares of a corporation may qualify as QSBS if the gross asset basis test is met immediately after the shares are issued (e.g., if new shares are issued when the company has an aggregate gross asset basis of $40 million).

However, if the aggregate gross assets of the company increase over time, a subsequent block of additional shares that are issued in your company later on may not pass the gross asset test, even if the other QSBS requirements are still being met and the previously issued shares still qualify as QSBS. To illustrate, this can happen if a company’s additional block of shares is issued at a time when the aggregate gross asset basis is $100 million; in this case, these additional shares will not qualify as QSBS, even if previously issued shares in the same company did.

What’s more, several of the requirements must be monitored and maintained over the course of the shareholder’s holding period. For example, the corporation must meet the active business test for substantially all of the shareholder’s holding period for its shares. Consult a tax professional if you have any questions related to the above.

Considerations for investors investing in QSBS

To review, below are a couple of things to keep in mind when determining if a company you’d like to invest in meets the QSBS exemption requirements:

Document your purchase. Keep track of each stock purchase in your portfolio, including the date you bought the stock and the amount you paid for it. Keep a copy of the cashed check or wire, along with an account statement showing the funds leaving your account. Don’t forget to save a copy of the share certificate, either.

Have your stock certified. If you think you’re investing in a company after the OBBBA date that may qualify for the QSBS exemption, confirm with the company that they adhere to the following stipulations:

As you can see, qualification for QSBS and the Section 1202 exemption is highly complex, and you should consult a tax advisor if you’re interested in learning more.

The bottom line

While this primer may not describe all the necessary requirements for company stock to qualify as QSBS (or the Section 1202 exemption), understanding the basics is an important first step to potentially harnessing it into your tax investment strategy. If you’re curious whether any stock you own qualifies as QSBS – or if you may qualify for any of the exemptions mentioned above – consult a tax professional to learn more. It’s important to note that not all states conform to federal QSBS treatment, so you should discuss with a tax professional the potential state tax implications.

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