The qualified small business stock (QSBS) exclusion was enacted into law in 1993 with a goal of increasing investments in small business by providing a 50% capital gains tax exclusion. The maximum capital gains tax rate at the time was 28% and as such QSBS provided tax savings up to 14%. Capital gain rates have since changed but the 28% maximum rate for QSBS has remained.

Qualified small business stock owners have two advantageous rules if the stock is sold at a gain:

1. Capital gain on the sale of QSBS can be excluded from income under Section 1202 of the Internal Revenue Code (Code).
2. QSBS gain can be rolled over under Section 1045 of the Code.

 

While employees of startup companies may be issued stock meeting the requirements of QSBS, more generally startups may use QSBS to raise capital, and we have noted increased interest in investments in QSBS through venture capital funds (as partnerships can hold QSBS).

To that end, a brief review of the basics follows. Let us know if you have questions about reporting a sale of your QSBS investment.

What is QSBS?

For stock to be considered QSBS, it must meet the following criteria:

1. A C corporation must issue the stock.
2. The total gross assets of the company must be $50 million or less at all times after August 10, 1993, before the stock is issued, and immediately after the stock is issued.
3. The corporation cannot be a:
   • Domestic international sales corporation (DISC) or former DISC,
   • Real estate investment trust (REIT),
   • Real estate mortgage investment conduit (REMIC),
   • Cooperative, or
   • Regulated investment company (RIC).
4. The stock must be original-issue stock. In other words, the issuer must issue the stock directly either in exchange for cash or property or as compensation (e.g. RSUs).
5. At least 80% of the company’s assets must be in the active conduct of one or more qualified trades or businesses during the taxpayer’s holding period. A qualified business includes any business except for:
   • Farming business, including raising or harvesting trees.
   • Banking, investing, insurance, financing, leasing, or similar business.
   • Business extracting or producing natural resources eligible for percentage depletion.
   • Business operating hotels, motels, restaurants, or similar business, or
   • Business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any other trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees.

 

Gain Exclusion

The treatment of QSBS gain is different for regular tax and AMT purposes. Part or all the gain from QSBS sales held for more than five years is not taxed for regular tax purposes. The portion that is taxable will have a maximum capital gain rate of 28%. For AMT, 7% of the excluded gain for regular tax purposes is added to alternative minimum taxable income. The 7% addback does not apply to QSBS acquired after September 27, 2010.

There are various gain exclusion percentages depending on acquisition dates (see chart below).

The gain eligible for exclusion is limited to the greater of:

• 10 times the taxpayer’s aggregate adjusted basis in the QSBS or
• $10 million ($5 million Married Filing Separately) reduced by the amount of the gain from the stock of the same issuer used to figure the exclusion in earlier years. It is a lifetime limit, per corporation.

 

For example, if a taxpayer invested $1,500,000 in a QSBS in 2015, they could sell the stock five or more years later for up to $15,000,000 and pay no Federal income tax on the gain.

Rollover Gain

QSBS held for more than 6 months then sold gives the taxpayer an option for a tax-deferred rollover of gain. The taxpayer must purchase new QSBS within 60 days. If the new stock costs at least as much as the realized proceeds from the sale of the old stock, the entire gain is deferred. If the new stock costs less, the difference is taxable to the extent of gain deferred. The new stock must meet the active business requirement for at least six months after purchase.

Does Section 1244 apply to QSBS?

Small business (Section 1244) stock allows taxpayers an ordinary loss on disposition versus a capital loss up to a maximum annual amount of $50,000 ($100,000 Married Filing Jointly). Amounts over these limits are treated as capital losses.

Section 1244 has different requirements. It does not apply to Section 1202 QSBS.

State Taxation

Most states conform to the Federal tax code regarding QSBS. However, Alabama, California, Hawaii, Massachusetts, Mississippi, New Jersey, Pennsylvania, and Wisconsin either do not conform or only partially conform to the Code.