Educational essentials

The qualified small business stock (QSBS) tax benefit

9 August 2023
The Carta Team

In this article:

What is qualified small business stock (QSBS)?

The qualified small business stock (QSBS) exclusion is a U.S. tax benefit that applies to eligible shareholders of a qualified small business (QSB). Because founding, investing in, and working for a startup can be riskier by nature, the QSBS exclusion helps encourage people to take that risk.

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.

Note: The following article is intended to be a general summary of QSBS. We strongly recommend talking to a tax advisor before making any decisions about exercising or selling any equity.

Qualified small business (QSB) rules for eligibility

A company is known as a qualified small business when it meets the below qualification requirements:

  1. The company must be an active business that is 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. At least 80% of a company’s assets must be actively used in a qualified trade or business. Excluded business types are determined by the IRS and include companies that:

  • Perform services related to health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, finance, banking, insurance, leasing, investing, or brokerage

  • Rely on an employee or owner’s reputation  (i.e. if it endorses products or services, uses an individual’s image, or has an employee make appearances at events or on media outlets.)

  • Produce products, such as fossil fuels, for which percentage depletion (a type of tax deduction) can be claimed

  • Operate a hotel, motel, restaurant, or similar business

  • Are a farming business

A company can be found unqualified for QSBS status after previously qualifying if the requirements above no longer apply. For a full list of requirements, see IRS’s Pub. 550 or Section 1202.

If your company uses Carta for 409A valuations, see whether you may qualify for QSBS in your dashboard. Carta shows which equity grants may be eligible for the QSBS exclusion and whether you’ve held the shares long enough to benefit from QSBS if you were to sell the stock.

QSBS attestation letter

 While Carta shows shareholders that their shares could be QSBS eligible, eligibility is not a guarantee. A QSBS attestation letter is a document that serves as a formal confirmation from your company that your shares meet the IRS requirements to be considered QSBS. Carta Tax Advisory performs an in-depth review of your company’s QSBS status and provides an attestation letter annually, which can be shared with investors and employees when filing taxes. 

What can cause QSB disqualification for companies

Certain actions by a company can disqualify its QSB status, and therefore impact shareholders’ ability to gain the QSBS tax exclusion. Here are some of the ways companies can be disqualified:

Share repurchases

If a company buyback of its shares exceeds a certain threshold, all shares issued one year prior to the buyback may be disqualified, and a one-year blackout period may be created where all shares issued after the share repurchase are not QSBS-eligible.

Cash management of investments

Investing company assets into non-cash deposit instruments, like corporate bonds or money market funds, with liquidity terms more than 24 months could impact QSBS eligibility depending on the amount and company age.

Business model changes

If your company was a qualified small business, but then changed its business model and begins to perform non-qualifying activities, your QSBS status may be affected.

Exceeding asset threshold

Under QSBS rules, your company must have less than $50 million in gross assets at the time of share issuance and immediately thereafter. Acquisitions, fundraising rounds, licensing agreements, and inventory can cause a company to exceed this threshold and lead to QSBS disqualification. Due to this $50 million threshold rule, companies tend to lose their QSBS status after they have raised multiple funding rounds.

Qualified small business stock (QSBS) rules for eligibility for shareholders 

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. Once you the hold stock, confirm whether your company is a Qualified Small Business, as defined by the IRS and outlined above. Only individuals,  trusts, or other pass-through entities may hold QSBS stock. 

QSBS holding requirements: What qualifies as QSBS?

You must hold your QSBS-eligible stock 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, you may sell your QSBS-qualified stock and potentially exclude up to 100% of capital gains from your federal taxes if you’ve met all required conditions. Tender offers (buyback events), bilateral secondary transactions, and IPO events are some of the ways you can sell private company stock.

How QSBS is handled in Investor Rights Agreements

While QSBS can help employees save up to $10M of federal capital gains tax-free, it can help investors save even more. QSBS protects up to 10x their investment from long-term capital gains taxes, up to $10 million invested. For example, an investor who put in $10 million could avoid paying federal capital gains tax on up to $100 million. 

For this reason venture capital and angel investors have a vested interest in making sure the companies they fund take advantage of QSBS rules. Investor Rights Agreements (IRAs) play a pivotal role in this context. The National Venture Capital Association provides an investor rights agreement template, used as the industry standard by many law firms, that states a company will take reasonable actions to maintain QSBS eligibility and, if requested, send the required information to claim QSBS to investors.

With Carta Tax Advisory, you’ll get the annual QSBS attestation letter and guidance you need to meet investor rights agreement requirements.

QSBS tax treatment & benefits

Normally when you sell shares, they could be subject to either short or long term capital gains rates. Short term capital gains rates may be as high as 37% whereas long term capital gains rates may be as high as 20%. QSBS status offers the ability to lock in a 0% capital gains tax rate for federal purposes. However, the tax benefits differ depending on when the QSBS shares were acquired.

Generally speaking, if you acquired QSBS-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 (AMT).

The thresholds, dates, and rules around QSBS might 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.

Can I lose my QSBS stock?

Once securities have been exercised and converted within the QSB eligibility window, the resulting stock is unlikely to 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. Whether the company has merged or has been acquired by another corporation. (Except if the company was acquired before the five-year period ended, in which case you would no longer be eligible for this benefit.) Note: In a merger or acquisition scenario, one of the following, or a combination, can occur, depending on the transaction: 1) QSBS holders may be able to conduct a share-for-share transfer in which shares are exchanged for shares in the acquiring company; in this case, QSBS status is maintained, but the capital-gains exclusion is capped at the transaction value rather than the full $10 million investment cap; 2) QSBS holders, for example high-net-worth individuals, may cash out and defer capital gains by investing into another QSBS company.

  3. Whether the stock has been transferred, gifted, or inherited. (Except if the stock was transferred to a partnership, in which case it would lose its QSBS status.)

The following are some examples of when stock may lose its QSBS certification:

  1. If the company performs a disqualifying repurchase. 

  2. If the company changes its business model and begins to operate as an excluded business type.

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. And while many state jurisdictions conform to the federal tax code for state taxes, some states do not.

As of today, if you (the shareholder of company stock) are a resident in one of the following states or territories, you are not eligible for the QSBS tax exclusion at the state level:

  1. Alabama

  2. California

  3. Mississippi

  4. New Jersey

  5. Pennsylvania

  6. Puerto Rico

Hawaii and Massachusetts partially conform with the QSBS tax exclusion. The requirements vary based on the state of incorporation (for the company) and the state of residency (for the shareholder). Reach out to a Carta Tax Advisor to learn more about how QSBS works in your state.

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 for QSBS tax benefits right from their Carta dashboard. They can also see how much longer they might need to hold their stock before selling it in order to take advantage of the QSBS benefit.

At Carta, our tax analysts conduct an in-depth review during your company’s 409A valuation to confirm QSB status. If your company qualifies, we’ll provide an attestation letter. To help your employees, Carta Tax Advisory also offers equity education , unlimited 1:1 sessions with an equity tax advisor, and QSBS tax filling guidance.

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