Do Your Shares/Options Qualify for QSBS?

Qualified Small Business Stock (QSBS) is one of the most attractive tax benefits available to startup employees, founders, and investors. If you're unaware, the tl;dr is that QSBS may allow you to exempt your entire capital gain from taxation (subject to multiple limitations).

However, it is also one of the most frequently misunderstood tax items. I've had dozens of individuals tell me they believe their stock will "qualify for QSBS" (and in a few cases, I've even been told this about stock options) -- when in fact it did not.

Suffice it to say, that while QSBS is a very attractive tax benefit that is worth planning for if you can/believe you're elgible, there is also a lot of misinformation about it. So let's dive into some details to help clear it up.

What Is QSBS?

QSBS is a special tax benefit under Section 1202 of the Internal Revenue Code that allows eligible investors to exclude up to 100% of capital gains on the sale of qualifying stock. But to do so, the shares need to meet a handful of criteria. If any of the criteria are not met, it will not qualify. Period.

If your shares qualify for QSBS, in most cases the greater of (1) $10 million or (2) 10x the original investment of capital gains may be excluded from federal taxation (as well as many, but not all, state taxes).

What Key Criteria Must Be Met To Qualify As QSBS?

The full list for QSBS qualification requirements exceeds the items below. Like many things regarding equity compensation and taxation, "it can be a bit complicated." So much so that there are tax attorneys that have full time business practices/services only related to QSBS.

That said, for most individuals, this 5-point checklist will likely give you a pretty solid indicator as to if (1) your shares do not qualify, or (2) if your shares may qualify

1. Held for Five Years. You must purchased the stock and owned it for at least five years prior to sale to be able to claim the sale under Section 1202/QSBS.
2. Company Had Gross Assets Below $50M at Purchase. The company you invested in/purchased shares from must have never had/exceeded $50 million in gross assets as of the date you acquired your shares.
3. Company Operates in a Qualifying Industry. QSBS only applies to certain industries. The majority of VC-backed companies end up qualifying, but certain industries such as finance/banking, consulting, and professional services are excluded from QSBS.
4. Company is a C Corporation. The company issuing the stock must be a C corporation at the time of issuance.
5. Purchased Directly from the Company. You must have acquired the shares directly from the company, not on the secondary market.

Other Key Things to Know (or Watch Out For)

1. The Exemption is Per Taxpayer ID. The QSBS exclusion applies per taxpayer ID. If you have a large gain that may exceed the $10m or 10x investment maximum, there may be an opportunity (via marital gifting, and/or trusts) to utilizing QSBS multiple times for the same company/security -- effectively excluding more gains from taxation.
2. State Taxation Matters. Most, but not all, US states conform to federal tax guidance regarding QSBS. Most notably, California does not conform to QSBS (sigh)
3. If Your Company is Acquired Prior to 5 Years of Holding, You May Still Qualify. Depending on the details of the acquisition (e.g. cash vs. stock), and/or certain actions you may have taken (a QSBS deferral), you may still be able to qualify for QSBS. It's uncommon, and requires careful planning, but it's possible in some situations.
4. Tender Offers Can Impact QSBS Eligibility. Too much to cover in this article, but if you previously participated in a tender offer with your shares, it may have invalidated your QSBS eligibility. You should research this further and/or consult with a professional.
5. Companies Who Appear To Not Be In An Eligible Industry Still May Be OK. Also too much to cover in this article, but there are at least a handful of companies/industries that appear to not qualify for QSBS, but actually may (e.g. neobanking). If you're uncertain, it is recommended you consult a professional.

Best Practices for Maximizing QSBS Benefits

1. Get Internal Confirmation from Your Company. If you believe your stock may qualify for QSBS, we recommend you get written confirmation regarding key facts from your company (preferably while you are still working there). Most specifically -- that the company did not have, and never exceeded, gross assets of $50m as of date you acquired your shares.
2. Seek a Qualified Opinion Letter When Claiming QSBS. Especially if the amount of QSBS exclusion you are claiming is large, it is likely worthwhile to get a qualified opinion letter. This will protect you in case the IRS disputes and disallows your QSBS claim (you will avoid penalties and fees on the unpaid tax).

Visit Our Knowledge Base For More Information About QSBS

This article provides high level details regarding QSBS. If you'd like to know more, visit our Stock Comp Knowledge Base.

A couple notable articles/pages within the knowledge base you may find helpful include:

• What is QSBS: A detailed overview
• QSBS Tax Planning Strategies

Disclaimer. This communication is for informational purposes only and is not intended as tax, accounting or legal advice, as an offer or solicitation of an offer to buy or sell, or as an endorsement of any company, security, fund, or other securities or non-securities offering. This communication should not be relied upon as the sole or primary factor in making any investment or tax strategy decisions. This information is not warranted to be from error. Your use of the information is at your sole risk.