The qualified small business stock (QSBS) tax benefit

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The qualified small business stock (QSBS) exclusion is a U.S. tax benefit that applies to eligible shareholders of a qualified small business (QSB). Since founding, investing in, and going to work for a startup is by nature riskier, the QSBS exclusion is one way to encourage people to take that risk.

What is QSBS?

The QSBS tax exclusion is set forth in Section 1202 of the U.S. Internal Revenue Code. When shareholders sell or exchange their qualified stock, the exclusion can provide a break on capital gains tax—potentially up to 100% exclusion of tax on capital gains

QSBS was designed to considerably decrease financial risk and tax liability by creating a powerful tax savings for startup shareholders. It was originally put into place in 1993 as a partial exclusion, and was expanded to 100% as part of the Small Business Jobs Act in 2010. 

This exclusion can motivate shareholders to invest within the small companies they helped build. As shareholders unlock the full value of their equity, they further fuel the high growth potential of those companies—and the innovation economy at large. 

Note: The following article is intended to be a general summary of QSBS.  It’s a great idea to talk to a tax advisor before making any decisions about exercising or selling any equity, and we strongly recommend that you do.

QSBS rules for eligibility 

When a company meets all qualification requirements for this tax break, it’s known as a qualified small business until found otherwise. Those requirements are as follows:

  1. The company must be incorporated as a U.S. C-corporation.
  2. The company must have had gross assets of $50 million or less at all times before and immediately after the equity was issued.
  3. The company must not be on the list of excluded business types

A company can’t be qualified for the exclusion if its principal asset is the skill or reputation of one or more employees. That umbrella includes consulting, sports, law, health, and financial services, among many others. The list of unqualifiable businesses also includes banking, farming, and hospitality services like restaurants.

A company can be found unqualified for QSBS status after previously qualifying. This typically happens when the company’s 409A valuation changes. Within this window of time, shareholders have the opportunity to exercise their grants for QSBS eligibility. 

If a company is using Carta for 409A valuations, shareholders will be able to see whether they may qualify for QSBS in their dashboard. Carta shows which equity grants may be eligible for the QSBS exclusion and whether they’ve held those shares long enough to benefit from QSBS if they were to sell the stock.

How do I get QSBS stock?

You must hold stock in a company, not options or other types of securities. You also must be an individual, a trust, or other pass through entity to hold QSBS stock. Your actual securities will only be QSBS-eligible after an exercise and conversion of options (including ISOs, NSOs, and ISO/NSO splits), warrants, or convertible debt into stock. Potential QSBS eligibility doesn’t have an impact on any exercise-related costs, taxes, or fees you may owe as a shareholder at the time of participating. 

Once a shareholder receives eligible shares purchased from the company or issued from an exercise of equity awards, they must hold them for at least five years in order to qualify for the tax benefit. If you hold eligible shares, you may be subject to tax liabilities on the sale of those shares if you decide to sell before the holding period has been completed.

When the five-year holding period is over, shareholders may sell their QSBS-qualified stock and potentially exclude up to 100% of capital gains from their federal taxes. Tender offers (buyback events), bilateral secondary transactions, and IPO events are some of the ways you can sell private company stock. 

Can I lose my QSBS stock?

Once securities have been exercised and converted within the QSB eligibility window, the resulting QSBS-eligible and QSBS-qualified stock will never lose its attributed tax benefit status and certification (as long as Section 1202 of the tax code remains in effect as currently written). That’s regardless of: 

  1. The company’s current QSB status (or lack thereof).
  2. The company merging or being acquired by another corporation.
  3. The stock being transferred, gifted, or inherited.  

How are QSBS shares taxed? 

The federal capital gains exclusion is limited to $10 million or ten times the adjusted cost basis—whichever is greater. Past that amount, any excess gains on the sale will be taxed at regular capital gains rates.

In addition to the limit, the tax benefit can differ as a result of when the QSBS shares were acquired. Generally speaking, if you acquired the eligible stock after September 27, 2010, you can exclude up to 100% of the qualified gain. If you acquired the eligible stock before September 26, 2010, you can exclude a smaller percentage of the qualified gain—either 50% or 75%, depending on the acquisition date, and a portion of the gains may be subject to the alternative minimum tax.

The thresholds, dates, and rules around QSBS might also be subject to change due to legislative action. Despite these limitations and thresholds, shareholders can claim the entire amount of eligible gains in one year, or spread it out over multiple years. If a shareholder works for multiple companies that qualify for the benefit, they can independently claim the tax benefit for each.

QSBS tax treatment and location eligibility

Since QSBS is an amendment to the U.S. tax code, only employees who are U.S. taxpayers can take advantage of this benefit. 

Many state jurisdictions conform to the federal tax code for state taxes. But some states have chosen to conform to the tax code only partially, while others have chosen not to conform at all.

States that do not offer the QSBS tax exclusion

If your company is incorporated in one of these states, your shareholders won’t be eligible for QSBS exclusion at the state level:

  1. California 
  2. Mississippi 
  3. Alabama 
  4. Pennsylvania
  5. New Jersey 
  6. Puerto Rico 

States that partially conform with the QSBS tax exclusion

If you’re incorporated in one of the below states, your company and shareholders need to know about some different regulations.

Hawaii

  • 100% of capital gains from the sale of QSBS-eligible stock will be excluded from federal income taxes.
  • 50% of the sale of QSBS-eligible stock will be excluded from state income taxes.

Massachusetts 

  • A company must meet all requirements and have been incorporated on or after January 1, 2011. 
  • Shareholders must have acquired their stock within five years of the businesses incorporation. 
  • Shareholders must hold their QSBS eligible stock for three years to qualify, instead of the standard five years. 
  • Capital gains will be taxed at a rate of 3% on state-level income taxes. 

For companies and shareholders that use the Carta platform for 409A valuations, understanding QSBS exclusion benefits is a lot easier. Shareholders can see any shares that might be eligible right from their Carta dashboard. They can also see how much longer they might need to hold their stock before selling in order to take advantage of the QSBS benefit.

That said, it’s always an excellent idea to talk about the QSBS exclusion with a tax advisor. Taking advantage of this benefit could allow you to unlock the full value of your equity as a reward for founding, investing in, or working at a startup.

DISCLOSURE: This communication is on behalf of eShares Inc., d/b/a Carta Inc. (“Carta”).  This communication is for informational purposes only, and contains general information only.  Carta is not, by means of this communication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services.  This publication is not a substitute for such professional advice or services nor should it be used as a basis for any decision or action that may affect your business or interests.  Before making any decision or taking any action that may affect your business or interests, you should consult a qualified professional advisor.  This communication is not intended as a recommendation, offer or solicitation for the purchase or sale of any security. Carta does not assume any liability for reliance on the information provided herein. ©2022 eShares Inc., d/b/a Carta Inc. (“Carta”). All rights reserved. Reproduction prohibited.

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