Qualified Small Business Stock: Common FAQs by Startup Founders and Investors

Related topic imageWe receive many questions from founders, investors and others about qualified small business stock. And it’s no wonder, given the complexity of the concept. In this article, we provide a high-level overview of QSBS. A cautionary note—because of the layers of nuance, while we are happy to provide a few of the basics, the advice and guidance of legal and tax professionals is essential to understanding it completely. As such, readers should seek such guidance when making any determination on the possible tax treatment of stock that they own.

What is QSBS?

QSBS stands for “qualified small business stock,” and it refers to a section of the United States tax code that provides a tax benefit upon the sale of company shares that meet certain criteria that comply with the statute.

So, if I have it, how does it help me?

If the shares and the company issuing the shares meet the criteria for “good QSBS,” and the shares are held for more than five years (more on that below), then the holder of the shares can exclude the payment of otherwise taxable federal capital gains from the sale of those shares up to a cap equal to the greater of (i) $10 million, and (ii) 10 times the holder’s aggregate basis in the shares. At the federal level (exclusive of state tax savings), QSBS savings equate to a 23.8 percent tax savings on the eligible amount.

Are founders shares always QSBS?

Not necessarily. But to answer this accurately, we first need to understand what companies qualify for QSBS treatment. At a very high level, the main criteria are:

  • The company must be a U.S. C corporation (LLCs and S corporations are not eligible) engaged in an active business, other than certain excluded lines of business (banking, hotels and restaurants, insurance, professional services and others).
  • The shares must be acquired directly from the company at original issuance (shares purchased from another shareholder are not eligible).
  • The company must have $50 million or less of gross assets immediately after the issuance of the shares.
  • The holder cannot be a corporation.
  • The shares must be issued for cash, services or other property.

QSBS is only available for actual shares. Other investments such as unexercised stock options do not qualify.

If an investor buys shares of the common stock from me that I received as a founder when I started the company, does that investor get the same QSBS treatment that I get?

No. To qualify for QSBS treatment the shares must be purchased directly from the company. Shares purchased in a secondary transaction such as this will not qualify for QSBS treatment. Investors that engage in secondary transactions with a founder should be aware of that.

I have heard people say, “Be careful not to mess up your QSBS treatment.” What does that mean? How can it be lost after I have it?

There are ways in which shares that otherwise qualified for the advantageous QSBS treatment could become disqualified. The most common mistake that a company can make which could threaten otherwise “good QSBS” is to make a “significant” redemption of shares. QSBS treatment may be lost if a company repurchases shares from a stockholder within certain window periods around the investment that it intends to have qualify for QSBS. Significant redemptions within one year before or after a stock issuance that are intended to qualify for QSBS will actually disqualify all shares made in such issuance. In addition, certain redemptions from the specific shareholder within a two-year window before or after the issuance of QSBS stock to that stockholder will cause the stockholder to lose QSBS treatment of the stock that would otherwise have qualified.

Another common foot fault in QSBS qualification is for a company to elect to be taxed as an S corporation. Since the company must be a C corporation when the stock is issued, an S corporation election can disqualify the founders from having QSBS. This is not an uncommon problem and can sometimes be fixed through appropriate planning.

There are other ways in which QSBS can be lost and as you can see, the above is also very nuanced, so be mindful of QSBS when transacting in the outstanding stock of the company generally, and always seek the advice of tax and legal professionals.

When do I know that QSBS will no longer apply?

One way in which you know that QSBS is no longer applicable to the shares issued in a financing is when the gross assets of the company immediately after the closing of the round are greater than $50 million. So, if you are raising more than $50 million, QSBS will not apply.

To conclude, we want to reiterate that QSBS is a complicated concept. There is a lot of information available for those who want to learn more, including short but informative videos and a quick guide by the Fenwick tax team. When trying to optimize for QSBS treatment, seek advice from tax and legal professionals; there are myriad traps for the unwary and it’s difficult to undo actions that have already been taken. Better to get it right the first time.