QSBS stock tax exemption: The entrepreneurs’ advantage

OLarry | June 25, 2024

QSBS tax exception for entrepreneurs

Entrepreneurs often speak in a language that can be confusing if you are not fluent in ‘founder’. Here, we will help distill and demystify one of the best tax strategies for preparing to start a new business: QSBS. Making the tax code work for you, you could see upwards of a $10M capital gains exclusion and, in fact, more if you choose to stack your QSBS exclusion.     

  • QSBS allows a shareholder to exclude gains arising from the sale of a company’s stock from taxable income.
  • You can exclude up to $10M in capital gains or 10 times your original investment.
  • To be eligible for the federal tax exclusion, the company must be a U.S.-based C corporation. State eligibility depends on the state, as not all states allow the exclusion.
  • Serial entrepreneurs should consider rolling their QSBS over into new QSBs to accelerate the holding period and increase the exclusion gain.

What exactly is what is QSBS?

Qualified Small Business Stock (QSBS) refers to shares (stock) in a Qualified Small Business (QSB). It was created as a tax incentive to encourage founders, early employees, and investors to risk joining, founding, or investing in a start-up, which encourages innovation and entrepreneurship. The specific Internal Revenue Code (IRC) that pertains to QSBS is Section 1202 and was originally enacted as part of the Budget Reconciliation Act of 1993, at which time gain exclusion was limited to 50-75% of the total eligible gain, depending on the date of the stock sale. In September 2010, these limits were amended to current-day levels, with the most recent update in 2015 making current exclusionary limits permanent. 

How does QSBS exclusion work?

Under Section 1202, shareholders of QSBS stock acquired after 9/27/2010 (the date the limit increased) can exclude the larger of either $10m in capital gains or 10 times their original investment from federal taxation upon the sale of the stock. If they originally invested $2M, they could exclude up to $20M in capital gains. If they invested $1K, they could exclude up to $10M in capital gains. Prior to 9/27/2010 a portion of QSBS excluded gain needed to be added back for AMT (Alternative Minimum Tax) purposes. However, any QSBS acquired after 9/27/10 is also excluded from alternative minimum taxation. 

Any gains excluded from capital gains tax due to QSBS treatment are also excluded from the 3.8% net investment income tax. 

How it breaks down

The qualified small business company you work for has just sold for $500M, and you own 2% of the company – making your share of the sales proceeds $10M. Let’s assume your cost basis (the amount you originally invested) is zero to keep the math simpler. 

If your stock did not qualify for QSBS treatment, you would owe the following taxes:

  • $10M X 20% capital gains tax rate = $2M in federal capital gain taxes. 
  • $10M X 3.8% net investment income tax rate = 380K in net investment income taxes
  • Total taxes would be $2,380,000. 

However, if the sale of your stock does qualify for the QSBS exclusion, you would save $2.38M in federal taxes. Note: states like California do not conform to QSBS treatment. California’s tax rate is up to 13.3%, which means you could owe up to $1.33M in taxes in this scenario. 

Effective tax planning to minimize taxation for QSBS

There are 3 different strategies that can be leveraged when anticipating a gain from QSBS stock. 

  1. 83B election: This strategy must be employed when the stock is granted. It allows the taxpayers to elect to be taxed on the fair market value of the restricted stock at the time of grant rather than at the time of vesting, which can greatly reduce the amount of tax owed. This election also triggers the holding period for QSBS to be the date of grant rather than the vesting date.
  2. Exclusion stacking:  If a QSBS holder anticipates that the stock gain will exceed the exclusion cap, they can gift the QSBS to their children either directly or via trusts. The children can then also claim the QSBS exclusion on their tax returns upon the sale of the stock. QSBS is generally viewed as being a per-taxpayer exclusion. However, arguments have been successfully made that holders of QSBS can gift shares to their spouse, who can then also exclude capital gains, effectively increasing the exclusion to $20M on a married filing jointly tax return.
  3. 1045 rollover: If the QSBS stock has not reached the 5-year holding threshold, the 1045 rollover allows the holder to roll the proceeds from the sale of the QSBS over to reinvest into another QSB. Allowing the holder to retain the original holding period, potentially resulting in an increase in the amount of gain excluded.

What if my company was acquired?

QSBS eligibility can also roll forward. Let’s say your company is acquired, with a portion of the purchase being made in cash and the remainder in stock in the acquiring company. Even if the acquiring company is not a QSB, your stock in the acquirer would carry over QSB status – allowing you to exclude gains further down the road should you sell. However, any additional appreciation in the acquired stock would be subject to taxation.

How it breaks down:

In our previous example, your company, of which you hold 2%, sold for $500M cash. Instead, let’s assume the $500M sale was split between $250M in cash and $250M in stock in the acquiring company; let’s call the acquiring company “Company B”. 

In this scenario, only the $250M in cash would be taken into account for gain calculation purposes in the year of the sale. The $250M in stock received in the acquiring company would not trigger an income event until you sold that stock further down the line. 

  • $250M in cash X 2% = $5M – your share in the cash proceeds. Excluded from taxes due to QSBS treatment
  • $250M in stock of Company B x 2% = $5M in fair market value on the date of the sale. 

2 years later, Company B is now worth double what it was on the date of the transaction, and you sell your shares for $10M

  • $10M in proceeds less $0 cost basis = $10M Gain
  • $10M Gain less than $5M of gain attributed to your original company’s stock, which qualifies for QSBS exclusion, results in only $5M in taxable gain. 
  • Total QSBS exclusion is $10M: 5M in year 0 related to the cash portion of the sale. $5M in year 2 after the sale of Company B’s stock 

How do you qualify for QSBS? 

To determine whether your stock options qualify for QSBS, you must consider the corporation’s eligibility requirements and the requirements of the individual shareholder who acquired the shares.

Corporation Eligibility Requirements to be a Qualified Small Business (QSB)

  • Must be a U.S.-based C Corporation. Being a C-corporation also allows founders to take advantage of the TCJA corporate income tax rates, which reduced them from 35% to a flat 21%.
  • Aggregate gross assets must not exceed $50m before and immediately after stock issuance
  • Must be an active business, not a passive investment company, meaning at least 80% of the corporation’s assets must be used actively in a qualified trade or business during substantially all of the shareholders holding period of the stock. 
  • No more than 10% of the corporation’s assets can be stocks or securities of other companies in which it does not own a majority interest.
  • Generally, the following industries are excluded from qualifying for QSBS treatment: health, law, engineering, architecture, accounting, actuarial services, performing arts, athletics, financial services, brokerage services, and consulting.

Stock Shareholder Requirements

  • The shareholder must have acquired the (QSBS) stock at its original issuance and paid for it in money or property, or it must have been given as compensation for services provided. This means the stock must have been acquired directly from the issuing corporation and not via a secondary market transaction.
  • The stock must have been held for at least 5 years before selling. If the company is acquired and stock is issued by the acquirer in exchange for the QSBS, the holding period still carries over. (similar to QSBS status mentioned above).
  • Must be actual stock held for the required holding period not stock options, meaning the options must be exercised first in order to start the holding period.

Any tax advice herein is not intended or written to be used.