Founders and investors can invest in a small business or startup by acquiring qualified small business stock (QSBS), which provides tax advantages. Section 1202 of the US Internal Revenue Code allows investors to exclude up to 100% of capital gains tax on certain small business stocks held for over five years. Almost $24 billion flowed into QSBS-eligible companies in 2021, which demonstrates the eagerness of investors to capitalize on these tax incentives.

But QSBS offers other advantages aside from capital gains exclusion. From gain rollovers to basis adjustments, the tax code for QSBS offers a dynamic set of benefits that savvy investors can take advantage of—if they adhere to all of the requirements, such as the QSBS holding period. Below, we’ll share more details about each benefit of QSBS and the specific requirements investors must abide by, including how long they must hold onto QSBS. Here’s what you need to know.

What’s in this article?

• What is qualified small business stock (QSBS)?
  
• QSBS eligibility criteria
  
• QSBS tax benefits
  
• QSBS holding period and timing
  

What is qualified small business stock (QSBS)?

Qualified small business stock (QSBS) is a special type of stock in US companies that offers certain tax breaks. The goal is to incentivize people, particularly founders and early investors, to invest in small businesses for the long term. For investors, the primary advantage is to avoid paying a large chunk of the capital gains tax when they sell the stock, as long as they meet specific requirements.

QSBS eligibility criteria

The substantial financial advantages of QSBS aren’t available to every business owner and investor. To qualify as QSBS, both the stock and the issuing corporation must meet a set of criteria that includes:

• Type of corporation: The stock must be from a C corporation. Other types of business entities such as S corporations or LLCs aren’t eligible for issuing QSBS.

• Asset ceiling: The corporation’s aggregate gross assets must not exceed $50 million before or immediately after issuing the stock.

• Qualified business activity: The corporation must engage in a qualified trade or business. This rule excludes specific industries such as hospitality, natural resource extraction, and financial services, among others.

• Stock acquisition: Investors should acquire the stock at its original issuance, directly from the corporation or via an underwriter. Secondary market purchases don’t qualify.

• Holding period: How long you hold the stock is a key factor for eligibility. We’ll explain more about this later.

• Usage of assets: At least 80% of the corporation’s assets must be used actively in a qualified business throughout most of the investor’s holding period.

• Conversion cases: Stock acquired through convertible securities can qualify, but there are specifics to consider, especially regarding the holding period.

QSBS tax benefits

Eligible QSBS investors gain several advantages by holding this type of stock.

Exclusion of capital gains tax

The most well-known advantage of QSBS is the exclusion of capital gains tax. Section 1202 allows investors to exclude up to 100% of capital gains on the sale of QSBS held for more than five years. This offers a substantial tax advantage for long-term investors in qualified small businesses. With federal capital gains tax rates that can reach as high as 20%—not to mention additional state taxes—the savings can be considerable. For investors seeking long-term growth, this tax break is a powerful motivator.

Deferral of gain through rollover

Section 1045 of the Internal Revenue Code allows investors to roll over the gains from the sale of one QSBS to another and defer taxation when they reinvest the proceeds from a QSBS sale into a new QSBS within 60 days. This offers a tax-efficient way to move from one investment opportunity to another without facing immediate tax consequences. This provision is especially useful for investors who regularly engage in capital rotation to maximize gains.

Step-up in basis

Beneficiaries who inherit QSBS from someone else can benefit from a “step-up” in basis to the fair market value of the stock at the time of the original owner’s death. This resets the stock’s cost basis, often reducing the amount of capital gains tax owed when the stock is sold. If you have inherited stock, work with a tax advisor who understands the specifics of your situation. But in most cases, the step-up in basis can offer substantial tax savings and simplify recordkeeping for heirs.

State tax benefits

Some states offer their own QSBS tax benefits that align with federal incentives, while other states might offer partial benefits or none at all. Because of this variation, state-specific tax planning is important for maximizing the utility of QSBS advantages. Pay careful attention to state tax benefits in order to optimize your tax situation.

Limitation on taxable amount

There’s a limit on the amount of capital gains that can be excluded: the greater of $10 million or 10 times the adjusted basis of the stock. But regardless of this limit, the exclusion is still quite generous and allows for substantial gains before any tax kicks in.

QSBS holding period and timing

The holding period is the foundation of QSBS eligibility. The rule says the investor must hold onto the stock for a minimum of five years, starting the day after the stock is acquired, to qualify for the tax benefits under Section 1202. For stock obtained through convertible securities—such as convertible notes, options, or warrants—the holding period clock starts ticking only after the conversion into stock. The goal of the five-year rule is to encourage long-term investment in small businesses, supporting economic growth.

Here’s how to adhere to the five-year QSBS holding period:

• Record the start date: Mark the exact date when the stock was acquired or, in the case of convertible securities, when they were converted into stock.

• Track your holdings: Maintain accurate and comprehensive records of your stock purchases and conversions. This will serve as evidence for the holding period.

• Consult tax advisors: Tax laws are subject to change, and professional advice can help you keep track of these changes as they relate to your holding period.

• Review asset usage: Keep an eye on the company’s asset allocation. At least 80% of its assets must be actively used in a qualified business for most of your holding period.

• Plan your exit: If you’re considering selling, make sure you’ve crossed the five-year threshold to take advantage of the tax benefits.