Qualified Small Business Stock (QSBS)

Founders, early employees, and early investors in businesses known as qualified small businesses, are entitled to recognize their shares as Qualified Small Business Stock (QSBS), which the IRS taxes favorably. Holders of QSBS are exempt from certain federal income and capital gains taxes (up to a $10 million limit). If you are involved or are considering getting involved in a small business, QSBS should be on your mind.

What is QSBS?
Qualifying for QSBS
Section 1045 Rollovers

What is QSBS?

QSBS is intended to incentivize the creation of and investment in small businesses across the United States. To do so, the IRS allows early shareholders, which includes founders, early employees, and early investors, the opportunity to qualify for a tax exemption of up to $10 million on any proceeds at an exit.

Said differently, if you have founder’s stock, Incentive Stock Options (ISOs), Non-Qualified Stock Options (NSOs), restricted stock, Restricted Stock Units (RSUs), or preferred stock, you could qualify for QSBS tax treatment. When working with a qualified tax professional, it is important to ask if you qualify for QSBS tax treatment on your shares. If you do not know what most of these terms mean, we encourage you to start with our article on the basics of Stock Based Compensation (SBC) here.

Qualifying for QSBS

QSBS tax treatment is a frequently overlooked benefit for stockholders. Many simply do not realize they qualify for it. There are a few basic criteria for your equity to qualify for QSBS:

  • You must hold stock in a company. You cannot hold stock options or stock units.
  • Your company must be a C corporation.
  • You must hold your stock for at least five years prior to a liquidation event.
  • You cannot acquire your stock from another party. It must come from the company in an original issue.
  • Your business must be in a qualified sector. While technology businesses tend to qualify, service businesses like restaurants or financial institutions like banks do not.
  • The company’s assets must be under $50 million at the time you received your stock.

The last bullet is important. If you work at a software or internet business that raises hundreds of millions of dollars, you can qualify for QSBS tax treatment by being granted shares early in the company’s life - before it has raised massive sums of money. The benefit of QSBS is that you can shield any gain up to $10 million or ten times your base investment, the greater of the two.

QSBS is another reason why early exercising can be a good idea. It helps early employees, investors, and founders start the clock on qualifying for a major tax benefit. It also justifies having a priced round early on in a company's life versus raising a convertible note because a shareholder must have actual shares in the company to begin qualifying for QSBS. Holding just options, restricted stock, or RSUs does not suffice. You can read more on early exercising here and more on convertible notes here.

When you early exercise, you must file an 83(b) election with the government. You do not need to file a document to qualify for QSBS tax treatment. If you are looking for more information, check out this article from Silicon Valley Bank, and please ask a tax professional to see if you qualify.

Section 1045 Rollovers

Let’s say you are holding your shares to qualify for QSBS tax treatment, but your company gets acquired two years before you hit the five-year mark. You do have the opportunity to roll your proceeds into a new investment within 60 days to keep the clock ticking and to avoid a taxable event. This ability stems from Section 1045 of the tax code. In the hypothetical described earlier, you could roll the proceeds from your sale into a new business or investment opportunity within 60 days and after two years, you will have collectively hit the five-year mark to qualify for QSBS tax treatment.

Now lightning does not always strike twice, and despite being successful with one business venture, it does not mean that the next one will turn out the same way. Reinvesting gains from a sale to receive favorable tax benefits does put your principal at risk. The value of your second investment could decline and wholly outweigh any of the tax savings you were hoping to achieve. That said, there are still merits to considering a Section 1045 Rollover for all or part of your proceeds from the initial sale.

All content herein does not constitute legal, tax, or investment advice for any purpose. Topics discussed or referred to on StockBasedComp are based on authorities which are subject to change. It is recommended you speak with a qualified professional to advise on your personal situation.