What is Qualified Small Business Stock?

Imagine investing in a startup, exiting five years later with a 10x TVPI, and not having to pay a dime in federal taxes on those capital gains. This scenario is possible thanks to something called the qualified small business stock gain exclusion.

In this guide, we’ll explore what qualified small business stock (QSBS) is and how its possible tax benefits can apply to venture investing. We'll also look at the numerous conditions that must be met in order to claim these benefits.

What is Qualified Small Business Stock (QSBS)?

Qualified small business stock refers to shares in a business that meets the requirements of a “qualified small business” (QSB) under Section 1202 of the Internal Revenue Code (IRC). For this reason, QSBS is also sometimes referred to as “Section 1202 stock.” To be eligible, the stock must meet the full IRC Section 1202 Qualified Small Business Stock checklist. The criteria include:

• The company issuing the stock must be an active, domestic C-corporation.
• The business must be a “qualified trade or business.” There are a wide variety of qualified businesses, including those in the technology, retail, wholesale, and manufacturing sectors. Hospitality, financial services, farming, mining, and personal services are all trades and businesses that are explicitly disqualified.
• At least 80% of the corporation’s assets must be used to conduct one of the aforementioned qualified trades or businesses.
• At the time of issuance (and immediately after the issuance), the corporation’s assets cannot exceed $50 million.

Investors holding such QSBS—if they meet certain criteria themselves—can enjoy a 100% capital gains tax exclusion up to the greater of:

• $10M
• 10x the original purchase price of the shares

Note that the investor must have obtained the QSBS on or after September 28, 2010 to be eligible at 100% exclusion.

The idea behind such incentives is to promote investments in small businesses, such as early-stage tech startups.

Benefits of QSBS

Simply holding QSBS does not automatically entitle an investor to its tax benefits. The shareholder must also meet the following criteria:

• The QSBS holder cannot be a corporation. However, it can be a pass-through entity, which includes S-corps, partnerships (which covers most VC funds), and trusts. In these cases, the QSBS tax benefits can pass through to the direct holder, such as the general partners (GPs) and limited partners (LPs) of a VC fund.
• QSBS tax benefits are only applicable to U.S. “persons”—meaning only U.S. citizens, residents and non-corporate entities domiciled in the U.S.
• The qualified small business stock must have been acquired directly from the relevant company—not via the secondary market. QSBS obtained through employee stock options, restricted stock units (RSUs), and convertible securities also qualify. Once acquired through these means, QSBS can then also be gifted, whereupon the recipient can enjoy the corresponding tax benefits.
• The QSBS holder must have purchased the stock with cash, property, received the stock as payment for services, or been gifted it from another QSBS holder.
• In the case of venture capital funds holding QSBS, an LP must be invested in the fund for the entire time the fund owns the QSBS to be eligible for QSBS treatment when the fund sells or distributes the stock.

The investor must also hold the QSBS for at least five years before liquidating it. The holding period can begin from the purchase date, vesting date (in the case of options and RSUs), or exercise date (for convertible securities).

However, if the sale happens before the five year QSBS holding period is over—but after six months from obtaining the QSBS—the holder can still enjoy the tax benefits if they meet the requirements of a QSBS rollover. Also called a “Section 1045 rollover,” the rules allow investors to defer gains on the sale of QSBS stock to the extent they invest those gains into another qualified small business within 60 days.

Breaking Down QSBS

If the above QSBS rules for both the issuing corporation and the holders are met, then investors can enjoy a QSBS gains exclusion of up to the greater of $10M or 10x the original purchase price of the shares.

This 100% capital gains tax exclusion also covers the Alternative Minimum Tax (AMT) and the Net Investment Income Tax (NIIT)–meaning that gains from the sale of any QSBS will not be subject to either the AMT or NIIT. Keep in mind that these qualified small business stock gain exclusion caps are calculated on a per issuer basis—not per year basis. Even if an investor progressively sells their QSBS over several years, the maximum capital gains tax exclusion will not change.

The sale or transfer of an investor’s equity interest in a VC fund, or any partnership, that holds QSBS does not count as a QSBS sale. For a QSBS sale to occur, the fund must have specifically liquidated its relevant QSBS holdings and allocated capital gains from the sale to its partners. In this case, the amount of possible QSBS tax exclusion the LP can claim would be listed on a Schedule K-1 issued by the fund.

QSBS Example

Imagine a VC fund invested $1M in a startup that qualified as a QSB at the time of investment. 7 years later, the startup goes public with a multi-billion-dollar valuation. Assume that, after dilution, the fund’s initial $1M investment is now worth $201M—for a total gain of $200M. The fund also exits its investment on the first day of trading and allocates the return amongst its partners.

For simplicity, let’s say that there are only 10 LPs in the fund and that they are entitled to 80% of the total gain (with the general partners taking the remaining 20% as carried interest). Each LP thus has $16M in capital gains.

Without the qualified small business stock gain exclusion, the total amount of tax that each LP would have to pay on that $16M gain would be (assuming the highest long-term capital gains tax bracket and that all of the gain is subject to the net investment income tax):

However, given that the requirements for QSBS gain exclusions were met, each LP can exclude $10M of that $16M capital gain. Therefore, the total amount of capital gains tax payable would be:

That’s a total tax savings of $2.38M per LP.

The same goes for the fund’s GPs. If we assume there are 2 GPs of the fund, then each would have a capital gain of $20M. Each GP would thus also get $2.38M in tax savings (as the total capital gains per general partner exceeds the maximum QSBS exclusion cap).

These benefits to investors are a huge incentive for startups to qualify themselves as QSBs. In fact, it’s not uncommon for investors to ask for representations and warranties from the startup stating that the securities being acquired are QSBS or even that it will take reasonable efforts to qualify the stock as QSBS. An example:

The Company shall use commercially reasonable efforts to cause the shares of stock issued pursuant to the Purchase Agreement, as well as any shares into which such shares are converted, within the meaning of Section 1202(f) of the Internal Revenue Code (the “Code”), to constitute “qualified small business stock” as defined in Section 1202(c) of the Code

Important Considerations Regarding QSBS’ Tax Benefits

While the tax benefits possible from the QSBS exclusions are highly attractive, there are certain considerations to keep in mind:

Redemptions

A stock redemption—where a company redeems shares from shareholders —can affect QSBS status. Redemptions that can jeopardize QSBS status are:

• Redemptions over $10K or 2% of the investor’s stock value at time of purchase. However, this will only jeopardize QSBS exclusion claims if such redemptions are carried out within a four-year period that starts two years before the stock was originally issued.
• “Significant” redemptions are carried out. These are defined as total redemptions exceeding 5% of all the issuer’s stock. Again, this will eliminate all stock of that company from QSBS eligibility only if such redemptions occur during a two-year period beginning one year before the stock was issued.‍

Documentation

To support such QSBS exclusion claims, it’s important startups keep all relevant financial statements and supporting documents that show they fulfilled all the QSBS rules at time of stock issuance and for the duration of the time eligible investors hold the stock. Investors may also want to include QSBS representations, warranties, and covenants in the financing documents.‍

QSBS is Subject to Change

Note that before 2010, the capital gains tax exclusion was lower at 50% and 75%—with a percentage of the excluded gain also subject to AMT. The Biden administration’s recent tax plan included amendments that would slice the current 100% exclusion cap in half. In other words, the current rate should not be assumed permanent.

QSBS is an important law that helps small businesses create new jobs. The BBB bill that the House passed has essentially eliminated it. We’ve reached out to the U.S. Senate to try and preserve it. Can you help?

QSBS in Summary

At present, qualified small business stock gain exclusion rules offer a huge benefit for venture investors, with the potential to literally save them millions in federal taxes. But to claim such savings, it’s crucial to first understand all the corresponding criteria and conditions to ensure such QSBS exclusion claims can be properly supported.

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AngelList is not a tax advisor. Specific circumstances related to Schedule K-1 should be directed to a professional tax advisor.