Qualified Small Business Stock (QSBS) Exclusion

Taxation is complex. We provide below what we believe are the key highlights for this tax type in a 2-3 minute read for reference purposes. It is not tax advice and does not discuss the vast majority of the finer points.

What Is the Qualified Small Business Stock (QSBS) Exclusion? When/How Does it Apply?

The Qualified Small Business Stock (QSBS) exclusion is a tax benefit for investors that encourages investment in small businesses. If stock meets the QSBS criteria, investors may be able to exclude part or all of the capital gains when they sell the stock. This means investors can potentially owe little or no capital gains taxes on the sale of QSBS.

For an investment to qualify for the QSBS tax exclusion, it must meet a large number of criteria. A more fulsome checklist can be found here, but the key items we most frequently encounter and strategize around for clients regarding QSBS are:

• The investment must be made in a C corporation that qualifies as a small business.

• The corporation must have had gross assets of $50 million or less at all times prior to the investment.

• The investment must be made through a primary, direct purchase of shares from the company. Secondary market purchases of shares do not qualify.

• The investor must hold the shares for at least 5 years before selling to qualify for the exclusion. If the shares are sold before 5 years, the exclusion will not apply.

• The business must use at least 80% of its assets in an active trade or business. Certain service businesses like health, law, consulting, and financial services do not qualify.

What Are the Current Tax Rates/Brackets

QSBS is a tax exclusion, not a tax. If a sale qualifies for QSBS, you are allowed to exclude a certain amount of the gain from federal tax. For investments made in 2011 or later, an individual is eligible to exclude 100% of their gain from federal capital gains tax up to the greater of (1) $10 million of gain, or (2) 10x their investment.

State Taxes Can Be More Complicated

Most, but not all, states conform to the IRS' guidelines for QSBS, meaning that most states allow QSBS-eligible gains to also be excluded from state taxation. As of 2023, the states that don't fully conform are California, Washington, Wisconsin, Mississippi, Alabama, Pennsylvania, New Jersey, Massachusetts, Hawaii, and Puerto Rico. For more info visit the QSBS Experts Website.

Withholding Requirements

QSBS is a tax exclusion, and as such, withholding does not apply.

What Types of Stock Compensation Does This Apply To?

Stock Comp Type	QSBS Exclusion Applicability
ISOs	Yes. Stock acquired via ISOs can qualify as QSBS if the purchase meets all the criteria. For more info see: ISO Stock Options
NSOs	Yes. Stock acquired via NSOs can qualify as QSBS if the purchase meets all the criteria. For more info see: NSO Stock Options
RSUs	Very rare. RSUs issued at FMV may qualify as QSBS if all requirements are met. But in practice, VC-backed companies typically do not start issuing RSUs until later-stages, when a purchase of shares would not quality (due to exceeding the $50m in gross assets rule). For more info see: Restricted Stock Units (RSU)
ESPPs	Very rare. Because ESPP shares are purchased at a discount, the tax treatment can be complex with respect to QSBS. That aside, ESPP programs almost never qualify for QSBS (due to exceeding the $50m in gross assets rule). For more info see: Employee Stock Purchase Plan (ESPP)
RSAs	Yes. Restricted stock awards provide actual stock ownership so can qualify as QSBS if all requirements are met. For more info see: Restricted Stock Award (RSA)
SARs	No. SARs settle in cash, not actual stock, so they do not meet QSBS stock ownership requirements. For more info see: Stock Appreciation Right (SAR)
Phantom Stock	No. Phantom stock settles in cash, not actual stock, so it does not meet QSBS stock ownership requirements. For more info see: Phantom Stock

Founders, investors, and early employees are the individuals who most frequently may have stock qualify for QSBS. In today's market, raising $50m in VC funds isn't uncommon for a successful company. Once they do, the firm exceeds the "gross assets below $50m at all times'' requirement and any purchases thereafter will not qualify.

Unique and Special Situations

The Prohibited Industry Requirement May Be More Flexible Than It Initially Appears

There have been situations where a company operating in an industry deemed "prohibited" for QSBS purposes has still qualified because they were able to make the argument that they are actually a technology company facilitating operations within the prohibited industry, rather than directly operating in the industry itself. With the right positioning and argument, the IRS has found some companies whose technology applies to a prohibited industry (e.g. healthcare; banking; real estate) does still meet the QSBS requirements.

QSBS "Stacking and Packing"

The QSBS exclusion is currently per taxpayer ID. Because of this, a QSBS "stacking" strategy, wherein one gifts QSBS-eligible stock to family members or uses trusts (each with their own taxpayer ID), can potentially allow the $10 million gain exclusion to be multiplied.

QSBS “packing” strategies may also increase the exclusion amount. The QSBS exclusion is the greater of $10 million or 10x the investor’s basis. Investors and founders may be able to take strategic actions to increase the amount of their investment above $1 million (e.g. a founder contributes intellectual property as part of the company funding, which is deemed to be worth multiple millions of dollars).

Potential Changes in QSBS Rules

There have been recent proposals to reduce or eliminate the QSBS gain exclusion. If legislation were to pass that changed QSBS requirements, it could significantly impact tax planning and strategies. Those holding QSBS will want to monitor changes in the law and work with advisors to determine the best next steps.

QSBS Rollover Prior to 5-years

Although the 5-year holding period is a requirement to claim the 100% QSBS gain exclusion, there are situations where you may need or want to sell your QSBS-eligible shares before meeting this timeframe. Section 1045 provides a solution through what is known as a QSBS rollover. A 1045 rollover allows you to defer the gain upon the sale of your initial QSBS stock by reinvesting the proceeds in new QSBS-eligible stock. The holding period of the new QSBS then includes the holding period of the old QSBS, allowing the clock to continue ticking until the 5-year requirement is met.