Qualified Small Business Stock Explained
Big profits with no taxes—it’s the ultimate dream for business owners and investors alike. Unfortunately, capital gains taxes on investments can be substantial and eat into profits. The greater your return, the greater your tax bill. However, for some business owners and investors, Qualified Small Business Stock (QSBS)—also known as 1202 stock, named after the section of the Internal Revenue Code that governs it—can offer relief from this trend.
Why Use Qualified Small Business Stock?
There are a few reasons a business might use QSBS. First, the tax breaks offered by QSBS are significant. For example, in the best-case scenario, an investment of $10 million that grows to $100 million could result in $20 million in tax savings. Smaller investments can benefit by the same margin. Second, QSBS was designed to reward entrepreneurs in certain industries and can also reward those who help build an entrepreneur’s dream. The combination of offering tax-free gains and a minimum 5-year commitment to realize those gains can be great for businesses looking to attract and keep top talent. Third, investors who might not otherwise consider investing in smaller businesses from certain industries may be more inclined to do so if the returns are potentially tax-free. Entrepreneurs can potentially add QSBS to their pitch deck to improve the appeal of their business and secure capital.
Do I qualify for Qualified Small Business Stock?
To qualify for the benefits of QSBS, a business owner or investor must meet at least the following requirements:
1. U.S. C Corporation: The business must be a U.S. C corporation. S corporations and LLCs do not qualify.
2. Asset Limit:The company’s gross assets must not exceed $50 million after April 9, 1993, or after the company was formed. (Valuation based on the asset’s original cost)
3. Active Business: The corporation must be actively engaged in a qualified business. It cannot be dormant or a holding company.
4. Qualified Business Types: The corporation must operate in specific industries, such as manufacturing, wholesaling, technology, or retail. Other types of businesses are generally excluded, though there may be some ambiguity, so it’s important to assess on a case-by-case basis.
5. Stock Purchase Requirements: The stock must be exchanged for services, money, or property when initially issued.
6. Documentation: Both the shareholder and the corporation must provide specific documentation to support QSBS eligibility.
What are the actual benefits of Qualified Small Business Stock?
Just how big the benefit depends on when the stock was acquired and how long it has been held onto:
| Date Acquired | Tax Rate |
| Before February 18th, 2009 | Exclusion of gain limited to 50%, 7% subject to alternative minimum tax |
| Between February 18th, 2009 and September 27th, 2010 | Exclusion of gain limited to 75%, 7% subject to alternative minimum tax |
| After September 27th, 2010 | If held for more than 5 years, there is no tax on the gain |
| If held between 1 and 5 years, taxed up to 20% on capital gains (regular capital gains tax) | |
| If held less than 1 year, taxed similarly to income |
Keep in mind that regardless of when the stock was acquired or how long it has been held, the limit for excludable gain is $10 million, or 10 times the investment.
Conclusion
QSBS offers a powerful advantage for business owners and investors. When a business qualifies, the benefits of this legislation can be game-changing. However, there are specific requirements that must be met—and consistently maintained—to fully realize these advantages. At Johnstun Law, we guide businesses through the complexities of QSBS, helping them understand the responsibilities and opportunities it offers to maximize profits. Reach out to us to learn how we can help your business boost gains and minimize tax liabilities!
Sources:
https://www.sba.gov/blog/qualified-small-business-stock-what-it-how-use-it
Important: This material was prepared by law firm staff for educational purposes only. Use this to spot issues to discuss with your lawyer, not as a replacement for a lawyer. You should not rely on this info. It may not be appropriate for your circumstances. It may be out-of-date or otherwise inaccurate.
