It has become rather popular for employers to issue stock or stock options as part of an employee’s compensation — even more so to the executive team, especially founders at startups. Such stock has a huge upside, especially if it can be classified as qualified small business stock (QSBS) for tax-free gains upon sale.
One of the tax code’s best-kept secrets, Section 1202 covering Qualified Small Business Stock (QSBS) was first introduced in 1993 to encourage investment and innovation. QSBS rules have evolved over time, and, as result of a revision made in 2010, as much as 100% of the capital gain from the sale of QSBS stock can be excluded from taxable income.
While many startup founders, early employees, and investors have benefitted from QSBS throughout the past 30 years, it is still a foreign term to many. In working with new clients over the years, I have discovered hundreds of thousands of dollars in overpaid taxes to the IRS on the sale of QSBS — with the returns signed by an accountant!
Here are five things you must know about QSBS stock.
What is QSBS stock?
Qualified small business stock is stock issued by a, generally, private company to an individual that can provide substantial tax advantages upon sale if it meets certain IRS requirements.
To be classified as QSBS:
- The stock must have been purchased from a domestic C corporation at original issuance.
- The stock must be in a qualified industry. The IRS’ list excludes some service businesses. The banking and insurance, farming, energy production and hospitality industries are also excluded.
- At least 80% of the value of the corporation’s assets must be used in the conduct of an active trade. In other words, it cannot just be a holding corporation of some sort.
- The stock must be held for at least five years.
- Immediately after the stock issuance, the corporation must have had less than $50 million of gross assets. It is okay for the corporation to exceed $50 million in gross assets after issuance, even during the five-year holding period.
While this may sound like a simple list of requirements, you would be surprised how many times founders make irreversible moves that disqualify what would otherwise be ownership in QSBS.
For example, a few years ago a group of founders sought tax advice from me as they were getting ready to sell their company, a C corp. I brought up QSBS, which was news to them. As we explored the possibility, I discovered their C corporation was originally a S corporation that was converted — disqualifying its stock from wildly advantageous QSBS tax treatment. Indeed, prospering from QSBS requires foresight (and the help of smart financial pros).
Why is QSBS stock so appealing? How is QSBS taxed?
As much as 100% of your gains (limited to the greater of $10 million of capital gains or 10 times cost basis) from the eventual sale of your QSBS may be tax-free.
The three levels of potential tax-free gains are:
- 50% for shares originally purchased before February 18, 2009.
- 75% for shares purchased between February 18, 2009 and September 27, 2010.
- 100% for shares purchased after September 27, 2010.
On potentially millions of dollars in gains from the sale of QSBS stock, a high earner in the top tax bracket could save tens of thousands, hundreds of thousands, maybe millions in taxes.
What about state taxes? Are QSBS stock gains tax-free in my state, too?
It depends on what state you live in when you sell the QSBS. While most states conform to the federal treatment of QSBS, there are a few exceptions such as California, Pennsylvania and New Jersey, where it’s taxed at their ordinary income tax rates.
Is QSBS transferable?
Unfortunately, selling QSBS to another person — for instance, from a small-business owner to a venture-capital firm — does not transfer the QSBS status to the next buyer. Taxpayers may only claim QSBS benefits on stock acquired at original issue.
On the other hand, if you gift QSBS to another person outright or via will or trust (say, to your children), the attributes of QSBS do transfer over. This is where there’s opportunity, considering the limits on the tax-free gains you can claim (the greater of $10 million or 10 times cost basis). Imagine you purchased two QSBS shares at $1 each, and each is worth $10,000,001 today. You decide to gift one of these shares to your neighbor. Upon sale of the stock, each of you will walk away with $10 million and a dollar in hand upon sale — and $0 in taxes owed.
Can I sell QSBS and use the proceeds to purchase QSBS from a different company?
You can execute a tax-free QSBS rollover by selling QSBS stock in one company, as soon as six months after acquiring the QSBS, and then using the proceeds to buy another QSBS investment within 60 days.