Qualified Small Business Stock (QSBS) for Founders

Greg O'Brien CPA

Published December 21, 2024

Understanding the QSBS Exemption: A CPAs Guide for Startup Founders

Navigating taxes might not be the most exciting part of building a startup, but it can make a world of difference to your bottom line when it’s time to cash out. For founders and early investors, one key way to maximize gains on a successful exit is by taking advantage of the Qualified Small Business Stock (QSBS) exclusion — a tax benefit that can drastically reduce or even completely eliminate capital gains taxes.

But like most things in the tax code, QSBS isn’t exactly straightforward. There’s plenty of misleading information out there, and the nuances can trip up even seasoned founders. The good news? You don’t have to tackle this alone. We’re here to demystify QSBS, cut through the noise, and show you how to position yourself to reap the rewards when it matters most.

What is the QSBS exemption or Section 1202?

Section 1202 of the American Internal Revenue Code offers a major tax break for investors in small businesses.

Put simply, it allows eligible investors to exclude a significant portion of their capital gains when selling QSBS. For startup founders and investors, this can mean substantial tax savings when a successful exit occurs.

How do you know if you qualify for the QSBS exemption?

The QSBS tax benefit is powerful but comes with a web of requirements and rules that must be met. Here’s a breakdown of what you need to know to determine if your business and its investors can benefit.

1. Must be a Qualified Small Business

Your company must be a U.S. domestic C corporation with gross assets that aren't worth more than $50 million at the time the stock is issued and immediately afterward. Gross assets include cash and the adjusted basis of any other property held by the corporation, including intellectual property.

For example, if your company was previously an LLC, the values on the balance sheet at the time of conversion will impact this asset limit. It’s critical to understand these thresholds to ensure eligibility for the QSBS exclusion.

2. Must acquire this stock directly from the company

The stock must be acquired directly from the company at its original issuance — whether through payment of money, property (excluding other stock), or as compensation for services. Put simply, buying stock from another investor won’t qualify.

It’s crucial to meticulously document how the stock was acquired, as this will be closely examined in the event of an IRS audit. Additionally, only non-corporate taxpayers, such as individuals, trusts, or partnerships, are eligible to hold the stock for QSBS benefits.

3. Must meet the five-year holding period

To qualify for the capital gains exclusion, investors must hold the QSBS for more than five years. If the stock is sold before meeting this timeframe, you won’t be eligible for the exclusion but may be able to explore a rollover option (covered in more detail in the FAQs).

If your business was previously an LLC, the five-year holding period only starts from the date of its conversion to a C corporation.

4. Must meet the active business requirement

To qualify for the QSBS exemption, at least 80% of the corporation’s assets must be actively used in the conduct of one or more qualified trades or businesses for the majority of the investor's holding period.

This means the corporation must engage in activities that directly contribute to its business operations rather than passively holding investments or assets. Examples of qualifying assets include inventory, equipment, and intellectual property that are actively being used for revenue generation through the production, sale, or delivery of products or services.

Additionally, the 80% active use threshold must be maintained throughout "substantially all" of the holding period, typically requiring consistent operational focus over at least five years. It's important to note that passive income-generating assets, such as investments in stocks, bonds, or rental income from real estate, do not count toward meeting this requirement. Companies must ensure their asset allocations support active business operations to preserve QSBS eligibility and secure the associated tax benefits.

Which kinds of businesses qualify for QSBS?

While many small businesses can take advantage of the QSBS exemption, certain industries and business activities are explicitly excluded. If your company falls under a Specified Service Trade or Business (SSTB), it will be ineligible.

Here is a list of businesses and sectors that do not qualify for QSBS:

• Finance and Investment: Includes banking, insurance, investing, lending, and financial advisory services.
• Professional Services: Businesses in fields like law, accounting, consulting, health, and brokerage services (e.g., stockbrokers).
• Hospitality: Hotels, restaurants, and similar establishments focused on lodging and food services.
• Farming and Agriculture: Engaging in traditional farming activities disqualifies a business from QSBS.
• Leasing and Rental Services: Companies primarily engaged in leasing or renting personal or real property.
• Entertainment and Arts: Includes performing artists, athletes, and businesses involved in artistic works, such as music, film, and literature.
• Personal Services: This category broadly covers businesses that provide services dependent on the skills and reputation of a single individual, such as hair salons and personal trainers.
• Mining, Oil, and Gas Extraction: Businesses engaged in extracting or producing minerals or other natural resources.

On the other hand, industries like technology, manufacturing, retail, and certain types of service businesses not classified as SSTBs do qualify for QSBS, provided they meet the active business and asset requirements.

How much can shareholders save with the QSBS tax exemption?

Section 1202 offers the potential to exclude up to 100% of capital gains from federal income taxes for qualifying QSBS, making it a powerful tax-saving tool for entrepreneurs and investors. However, even if you do everything right, you may not get savings on 100% of your capital gains.

Here are a couple of stipulations you should keep in mind when planning for a QSBS exemption:

• Exclusion percentage: For QSBS acquired after September 27, 2010, up to 100% of the gain on its sale can be excluded from federal taxes. QSBS stock acquired between February 18, 2009, and September 27, 2010, qualifies for a 75% exclusion, while stock acquired before February 18, 2009, allows for a 50% exclusion.
• State considerations: Be aware that some states offer a QSBS exclusion that aligns with federal limits, while others do not.
• Gain limitation: The maximum exclusion amount is the greater of $10 million or 10 times the investor’s basis in the QSBS. Gains exceeding these thresholds will be subject to federal tax, though advanced tax strategies may help founders surpass the $10 million limit.
• Alternative Minimum Tax (AMT): Gains excluded under Section 1202 for stock acquired after September 27, 2010, are not subject to the AMT, offering a significant additional tax benefit, as the AMT often reduces the value of other tax preferences.

What are some common misconceptions about Section 1202?

Over the years, we have received dozens of inquiries from both investors and business owners who misunderstood this tax code section. Given it has changed multiple times over the years, this is understandable.

Here are three common misconceptions a lot of people have about this part of the tax code:

1. Only founders can benefit from Section 1202

While startup founders can certainly benefit, any investor acquiring QSBS under the right conditions can take advantage of the exclusion. This includes employees, angel investors, and venture capitalists who receive stock directly from the issuing company.

However, remember, if the VC acquires the stock from an existing investor, this would not be a qualifying transaction.

2. All small businesses qualify

Not all small businesses qualify for Section 1202. The company must be a C corporation and must be engaged in a qualified trade or business. Excluded industries include professional services, banking, farming, and hospitality. It is important to work with your CPA to ensure the company meets the qualified trade or business requirements.

There are also a lot of startups we find disappointed to learn that the time they spent as an LLC (or partnership) did not “start the clock” for the holding period requirement.

3. QSBS eligibility is automatic

Investors must diligently track and document their QSBS holdings to ensure they meet all requirements necessary for claiming the exclusion, as the burden of proof lays squarely on you, not the IRS.

There are several potential pitfalls to watch out for, including:

• Significant redemptions of stock from related parties: This common issue arises when the company redeems a large portion of founder stock, which can jeopardize the QSBS status for other investors.
• Improper balance sheet valuations: If a venture capital infusion pushes your company’s gross assets over $50 million immediately upon receipt, it may disqualify the transaction. Careful monitoring is key to maintaining compliance.

Get tax planning help to master QSBS rules and more

QSBS Section 1202 provides a powerful tax incentive for investors in small businesses by offering substantial exclusions on capital gains for qualifying stock. However, navigating the complexities of QSBS requirements can be challenging, and even minor missteps can jeopardize this valuable benefit for founders and investors.

To maximize your QSBS advantage, it’s crucial to carefully document your eligibility at each stage, especially as your balance sheet evolves. Related-party transactions, for instance, should be closely reviewed with your CPA or legal counsel to prevent unintended disqualification.

Savvy startups that understand and leverage QSBS can attract and secure investor interest more effectively. By educating investors on this lucrative tax benefit, they position themselves for strategic growth and efficient capital raising.

Ready to unlock the full potential of your tax savings? Book a call with Digits to connect with our tax advisors so they can guide you through the QSBS landscape and help you maximize your benefits every step of the way.

FAQs about Section 1202

How does Section 1202 interact with state taxes?

State tax treatment of QSBS gains varies. Some states, like California, do not conform to the federal QSBS exclusion, meaning gains may still be subject to state taxes. Investors and startups should discuss this with their CPA or tax strategist.

What happens if I don't hold the stock for five years?

If the QSBS is sold before the five-year holding period, the investor cannot claim the Section 1202 exclusion and must pay capital gains tax on the sale.

However, under certain conditions, the holding period can be "tacked" when QSBS is acquired through certain tax-free exchanges. This does not include a conversion from a partnership.

Can I roll over gains into the new QSBS?

Yes, under Section 1045, investors can defer recognition of gains by rolling over proceeds from the sale of QSBS into new QSBS within 60 days.

This is a tight time frame, but you are allowed to take the cash in before redeploying it into a new Qualified Small Business investment within 60 days.

Are there limits on the amount of gains I can exclude?

Yes, the exclusion is limited to the greater of $10 million or 10 times the investor’s basis in the QSBS. Gains exceeding these thresholds will be subject to federal capital gains tax.

However, the 10x basis provision allows those who have appreciated IP outside of the corporation (perhaps in the original LLC) to contribute this IP at Fair Market Value and potentially increase their gain thresholds. This is known as “basis packing.”