What is a Qualified Small Business Stock?

The Qualified Small Business Stock (QSBS) Tax Exemption is one of the most impactful yet least understood tax exemptions for business owners. It comes from Section 1202 of the Internal Revenue Code, which states that any Qualified Small Business shareholder can sell their qualified stock, aka ownership in the company, and will be exempt from capital gains on that stock, up to the greater of $10 million or 10x the initial investment.

So, how do you know if your business is considered a “Qualified Small Business?” At a high level the criteria is focused on the structure, size, and purpose of the business. The business needs to be organized as a C corporation domiciled in the United States, and the company must operate in a qualifying industry. To quantify which “small” businesses can benefit, the company’s gross assets must not exceed $50 million at any time before and immediately after the issuance of the stock. Finally, at least 80% of its assets must directly support the business’s operations.

The business owner’s investment itself must also meet certain criteria to receive the preferential tax treatment. The investment must be in the form of common stock, as opposed to stock options, convertible debt, and other types of beneficial interest. The stock must have been purchased at issuance directly from the company, and the investor must have provided money, property, or service in exchange for the shares. Additionally, the investor must be a person, and the shares must be held for at least five years.

Now you may be asking yourself, “$10 million of capital gains is a lot of money! Why would the IRS provide this type of exemption?” Well, the IRS recognizes that small-to-medium-sized businesses are the life and blood of our local communities and drive the US economy forward. Yet, at the same time, starting a business is extremely difficult, so an entrepreneur needs to weigh potential risks and rewards of their idea before starting a new venture. By creating this tax exemption for Qualified Small Business, the IRA is incentivizing the creation of new businesses in hopes that increased entrepreneurship and innovation ultimately benefit the US economy as a whole.

Now this is only the tip of the iceberg as it relates to QSBS, and the criteria leaves plenty of nuance to sift through when evaluating real life businesses and investments. And even if you determine that you don’t qualify for the QSBS exemption, you may still be able to benefit from other strategies to make the sale of your business more tax efficient. Contact us at Regent Peak Wealth Advisors to learn more and always consult a qualified tax advisor before making any decisions around the structure of your business.

DISCLAIMER: Regent Peak does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.