One of the lesser known tax breaks that’s available for small businesses is the Qualified Small Business Stock Exemption. It was originally passed into law in 1993 to encourage small business growth and entrepreneurship. It’s very technical, but if you qualify you can legally avoid getting taxed.
What is Qualified Small Business Stock?
Qualified Small Business Stock (QSBS or Section 1202 Stock) is a type of stock that gets special tax treatment. The tax treatment is special in the sense that you may not have to pay any tax. That’s right, you can legally avoid getting taxed by Uncle Sam! However, anything that the IRS gives you that is a tax break, you need to qualify first.
How do I qualify for QSBS?
In order for your Small Business Stock to qualify as QSBS you will need to follow the following rules:
- The stock needs to be originally issued from a Domestic C Corporation (S Corps don’t count)
- The holder of the shares cannot be another C Corporation
- The shares must have been either purchased by cash, or exchanged for services or property
- You must have held the stock for over 5 years
- The Corporation that issued the shares must have had less than $50M in assets at the time you acquired them
- 80% of the Corporations assets must be used during the 5 year periods in a Qualified Trade or Business
How much tax can I save?
The maximum tax-free gain you could potentially have is $10 Million or 10x the basis of the stock (if you purchased the QSBS). Depending on what year that you purchased QSBS, you get different tax breaks. Here is a breakdown of the tax breaks you can get, based on when you purchased the stock:
|Date Stock Issued
|How much of the gain you pay tax on
|8/11/1993 thru 2/17/2009
|2/18/2009 thru 9/27/2010
|9/28/2010 thru today
For example, you have stock that was issued in 2012 and sold it in 2021, you could potentially pay zero tax! Keep in mind, the maximum gain that is tax free is $10 million or 10x the basis of the stock, which ever is greater. So if you purchased the stock for $2M, your maximum tax-free gain is $20 million.
What is a Qualified Trade or Business?
A Qualified Trade or Business is almost any type of business. However the IRS excludes certain types of businesses, such as:
- Personal services business (such as law practices, accounting, architecture, consulting, etc.)
- Banking, Insurance, Financing, Leasing, or Investing
- Hotels, Motels, or Restaurants
- Businesses engaged in depletion (e.g. oil & gas companies)
- Any business that may be similar to any of the ones listed above
Good news, if you work at a tech company and the business trade doesn’t fall in the list above, there is a chance your stock might be QSBS.
What if I’m an S-Corporation or LLC first?
As mentioned above, the stock must be issued by a Domestic C Corporation in order for it to count as QSBS, however, if your company is originally an S Corporation or LLC first, and later on becomes a C Corporation, new stock issued may be eligible for QSBS. The S Corporation may also exchange it’s assets as a C Corporation for QSBS, however that’s more complicated.
What if I have stock options?
As mentioned before, you must have held the stock for at lease five (5) years for the stock to qualify as QSBS. Having an option doesn’t count since QSBS has to be a security. The SEC has clearly defined that options are not securities. However, if you exercise the option, you may be able to roll it over to new QSBS through a 1045 rollover.
QSBS 1045 rollover
Similar to a 1031 exchange, you may defer the gain of your QSBS if you roll it over into new QSBS. However, just like a 1031 there are certain rules you will need to follow:
- The original QSBS must be held for 6 months before it is sold
- If you rollover only a portion of your QSBS, (less than 100%) a gain will be calculated on a pro-rata basis
- You must purchase the “new” QSBS within 60 days of selling your original QSBS
- You must make an election on your tax return that you’re making a 1045 rollover
- The holding period of the original QSBS is added to the holding period of the “new” QSBS, which is helpful if you have options.
Another great thing about a 1045 rollover is that if you don’t meet the 5 year holding period test, if you’ve held your stock for at least 60 days, you can roll it over to a new QSBS until you meet the 5 year period.
Common Questions regarding QSBS
Q: When does my holding period start if I have options?
A: Your holding period starts on the date you exercise your option, not on your grant date
Q: When does the C Corporation need to have less than $50M in assets for the stock to qualify?
A: The date that you purchased the shares or exercised your options, not on the grant date.
Q: What if the Corporation pivots and less than 80% of the assets start being used in a non-qualified trade or business?
A: The C Corporation must be in a qualified trade or business for the entire 5 year holding period if you want your stock to qualify as QSBS.
Q: Are there any threats to the QSBS?
A: Currently there is talk in Congress to remove the 0% preferential tax treatment. A any new tax laws regarding QSBS gets passed, we will update this page with the most current information.