What is the qualified small business stock (QSBS)? Millions in tax savings, maybe

Imagine selling your startup and having to pay $10M in capital gains tax. Now, imagine the same transaction, but you get to keep it. 

The difference is the qualified small business stock (QSBS) program.

Companies and stockholders that qualify can be exempt on up to $10M in federal capital gains taxes or 10 times their initial investment. The big condition is that your startup and the sale must meet specific qualifications, hence the program name, qualified small business stock (QSBS). It’s all outlined in a section of the U.S. tax code and was placed there to encourage people to invest in small businesses and startups.

In this guide, we explain it in plain English based on our experience helping 2,000+ fast-growing startups with their finances and back office. It covers what you and your investors stand to gain, how you can earn or lose qualified status, and whether it’s even worth your time.

Is QSBS worth your time? 

That depends on whether you meet the requirements and will continue to meet them throughout the period people hold the stock. If the startup pivots to a new industry or model, it may lose its qualification. If you know that’s coming, it may still be worth issuing stock, but just know that your stockholders will have to pay the federal capital gains tax when they sell.

On the stockholder side, whoever holds the stock must be an individual, trust, or pass-through entity such as an LLC or partnership, and hold the stock for at least five years—even if the business doesn’t last that long. The same goes for investors—they must invest through a pass-through entity or trust.

There are four requirements to be a qualified small business (QSB) that can issue QSBS-eligible stock:

• Be a domestic C corporation
• Gross assets of $50M or less
• 80% of assets actively used in a qualified trade*
• Remain engaged in that business, not shut down, merge, or sell

What’s a qualified trade? The law only tells us what isn’t qualified—everything else is.

• Disqualified industries: Professional services such as law, architecture, and engineering as well as healthcare, financial services, hospitality, farming, athletics, performing arts, restaurants, and more.* 
• Qualified industries: Everything else, including technology, retail, food, construction, recruiting, and so on.

*See the full list of unqualified industries.

Note that a “letter of attestation” is not an actual requirement on the above list. Investors may ask you for such a letter but it is not strictly necessary. This letter is an official document prepared by a specialist who audits your program to attest to all, including the IRS, that your program qualifies. 

In our experience, letters of attestation are expensive and unnecessary unless investors insist. While it can be helpful documentation for future tax filings, the IRS ultimately decides QSBS qualification at the time of sale, not at stock issuance. Meaning, you can be a qualified business with a stock program and everyone realize those benefits with or without the letter.

Benefits of QSBS: Saving on capital gains tax

To be clear, you can launch a stock program without worrying about any of this. Many startups do. This isn’t like running a public company where you are beholden to the SEC. It’s optional. You opt into being a qualified business because you want to realize tax savings and offer them to your investors.

Benefits include: 

• You as a founder and your investors are exempt from up to $10M in capital gains taxes or 10 times your original investment when you sell the company.
• You are also exempt from the alternative minimum tax (AMT)

That’s a pretty good deal for the investor. That means if they invest $1M in a startup and it appreciates to $50M, and they get a huge tax bill for $10M when they sell, they don’t have to pay it. (We’re using theoretical numbers here and assuming a 20% capital gains tax.)

An important caveat: This is a federal program for federal taxes. Most states follow the federal rule, but there are exceptions. If you file your taxes in one of the following, you’ll likely have to pay state- or territory-level capital gains taxes:

1. Alabama
2. California
3. Mississippi
4. New Jersey
5. Pennsylvania
6. Puerto Rico

How the program works

Let’s talk details. To launch a QSBS stock program, you simply have to launch a stock program (many people use services like Carta), meet the requirements, and issue stock along with your balance sheet as evidence.

Your “qualified” status is ephemeral. There are five ways the stockholder or the business can lose it:

1. The individual doesn't hold the stock for five years.
2. The individual didn’t originally hold the stock and purchases it from someone else (secondary sale stock loses its exemption).
3. The qualified company moves into a disqualified trade.
4. The company diverts more than 20% of its assets into a disqualified industry or business model.
5. The individual purchases new private company stock but their purchase drives the assets of the company above $50M.

The first point is important. If the holder sells early, their shares lose their status. For example, if they sell at four years and 11 months, they’ll have to pay the usual long-term federal capital gains tax (1-5 years). If they sell at 11 months, it’s taxed as ordinary income (less than one year).

The fifth point is important too: A company could have been QSBS eligible historically and on track for all stockholders to claim the exception, but then an investor purchases private shares during the Series B when assets exceed $50M. In this case, the stock is no longer QSBS eligible. 

If you plan on raising several rounds of funding quickly, then yes, losing QSBS status is almost inevitable. As companies raise, they quickly phase out of being a “small” business.

In the event of an IPO, stockholders must still hold the original QSBS private shares and must continue to hold those shares for the full five years. But this is rare—usually the shares are automatically converted to public shares, in which case, they lose their QSBS status. (This is primarily because IPOs rarely raise less than $50M, and thus, the company is no longer a qualified “small” business. It is rare, but not unheard of: Snowflake had to deal with this.)

There is at least one workaround to preserving your investment’s QSBS startup in the event of an IPO: If an investor needs to liquidate their investment before the five-year period, they can use a 1045 rollover where they roll the capital from one QSBS eligible investment to another. 

What about in the event of a tender offer, where the qualified small business plans to sell private shares to another entity? If that transaction occurs before the five-year holding period, the company and those shares lose their QSBS status. (Though as with an IPO, stockholders could perform a 1045 rollover within 60 days to preserve the tax benefit.)

The IRS is keen to manipulation. According to the program, companies cannot repurchase over 5% of outstanding shares within two years before or after issuing QSBS stock. That’s because the company could be using that cash to buy back shares to lower assets below $50M.

Finally, the qualified business must really continue to operate in the trade it claims to be in. Qualified companies cannot invest too heavily in treasuries or equities, say with 20% or more of their assets, because then they’re just an investment firm, which is a disqualified trade. 

Basically, QSBS is intended to help promote small business growth by supporting investment.

Nitty-gritty details

For a full list of requirements, see IRS’s Pub. 550 and Section 1202 where you’ll find the full list of disqualified trades, also below.

Specifically, a qualified trade is any business that is NOT:*

• A business involving services performed in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services.
• A business whose principal asset is the reputation or skill of one or more employees.
• A banking, insurance, financing, leasing, investing, or similar business.
• A farming business (including the raising or harvesting of trees).
• A business involving the production of products for which percentage depletion can be claimed.
• A business of operating a hotel, motel, restaurant, or similar business.

Curious about QSBS? 

Send us your questions at info@pilot.com and we’ll add to this guide. Or talk to one of our CFO advisors.