By: Steve Masur
In simple terms, a qualified small business stock (QSBS) is the stock or share of a qualified small business. It is defined as a domestic and active C-corporation whose gross assets do not exceed $50 million as of the date the stock was issued and immediately after issuance. Section 1202 of the Internal Revenue Code defines a qualified business as one that does not operate in the hospitality industry, financial sector, farming business, and any business that depends on the skill of one or more of its employees such as accounting, law, health, consulting, etc. The businesses that do qualify include companies in the wholesale, retail, technology, and manufacturing fields.
In order to qualify as QSBS, the following requirements must be met:
- The issuer must be a domestic C Corporation that does not have more than $50,000,000 in aggregate gross assets, including amounts received upon issuance of the stock. Gross assets mean cash and the adjusted basis of other property.
- The issuer must use at least 80% of its assets in the active conduct of one or more qualified trades or businesses for substantially all of the holding period of the stock. Assets used in business start-up activities and R&D are generally treated as used in an active business.
- The issuer must not have violated certain rules against certain redemptions of its own stock.
- The issuer must submit periodic reports to the IRS and shareholders detailing its compliance with the requirements of small business corporation status.
It is important to note that even if the stock qualifies initially as QSBS, this status may be revoked as to one or more shareholders in the future if some of the requirements are not met on an on-going basis.
A QSBS is any stock that was acquired from a qualified small business after August 10th, 1993. In order for the investor to claim the stock as qualified for tax purposes, they must have acquired the stock at its original issue (primary market) with cash or property as a payment for service. In addition, it is not enough to just purchase or acquire the stock; the investor has to have held the stock for at least five years to reap the tax benefits of a qualified small business stock.
Tax treatment for shareholders:
- Stock acquired after September 27, 2010: If it’s held for more than five years, there is no tax on the gain. It is free from income tax, alternative minimum tax, and the 3.8% net investment income tax. If it’s held for more than one year but not more than five years, the gain is treated like any other capital gain taxed at up to 20%. If the stock is held for one year or less, the gain is a short-term capital gain that is effectively taxed as ordinary income.
- Stock acquired between February 18, 2009, and Septemeber 27, 2010: If it’s held for more than five years, then 75% of the gain is excludable from gross income. In addition, 7% of the gain is subject to the alternative minimum tax.
- Stock acquired before February 18, 2009: The exclusion of gain is limited to 50%, and 7% of the gain is subject to the alternative minimum tax.
Benefits of QSBS
When you sell qualified small business stock, you may be eligible for up to 100% exclusion from federal income tax. This means that when you sell your qualifying stocks, you will avoid federal tax fees on gains of up to 10 times your tax basis. Many entrepreneurs who don’t know about QSBS and its potential benefits may be missing out on possible savings in future endeavors.