Word is spreading about the qualified small business stock (QSBS) exclusion. QSBS allows up to 100% tax exclusion of gain from the sale of stock in certain small businesses, including many technology start-ups. Gain is excluded from income for both federal regular tax and alternative minimum tax (AMT). If your company stock meets the requirements, you may not have to pay any tax on gains from the sale of your shares, or you may be able to defer tax on any gains using a QSBS rollover.
If you don’t know about QSBS yet, keep reading. The key rules related to individual taxpayers are summarized below. While QSBS rollovers to defer taxable gain are not covered in this article, all of the rules below also apply to QSBS stock with gain you might later decide to roll over.
All that said, the rules for the QSBS exclusion are highly technical—you’ll need to review them carefully for your specific situation to see if you qualify.[1]
Rule #1: A Domestic C Corporation Must Issue the Stock
The first requirement to be considered qualified small business stock: A domestic C corporation must issue the stock. Most major U.S. corporations are organized as C corporations, as are most venture capital-backed start-up companies.
Your shares must be “original issue” shares, meaning you purchased them directly from the company or you received them directly from the company as compensation. If you bought shares on a secondary market or from another person who acquired them directly from the company, those shares would not qualify as QSBS because you did not purchase them directly from the company.
Rule #2: The Company Must Be “Small”
The gross assets of the company must be $50 million or less at all times before, and immediately after, the company issues stock. The company must also be an “active business,” with 80% or more of its assets used in a “qualified trade or business.” The idea here is that the company must be an operating business and not an investment vehicle.
Rule #3: The Company Can’t Be in an Excluded Industry
The definition of a “qualified trade or business” excludes certain industries such as services (including health, law, engineering, architecture, accounting, consulting, performing arts, and athletics), hospitality, banking, finance, farming, and mining. Most technology companies would meet the definition of a “qualified trade or business.” If the company purchases its own stock (share buyback) around the time it issues stock, the QSBS exclusion may not be allowed.
To understand whether the company meets these requirements related to the company’s finances, share purchase history, and issuance history, your best bet is to consult with your company’s chief financial officer or other finance team members.
Rule #4: You Must Hold the Stock for Five Years
If you received common stock from the company as a founder or employee, so-called “restricted stock,” your five-year counter starts when you receive the shares. Each new stock grant starts a new five-year counter when you receive those shares.
However, stock options do not qualify for the QSBS tax exclusion. You must exercise your stock options, purchasing shares from the company, and then hold the shares for five years to qualify for the exclusion. The five-year counter begins at exercise of the option, when you actually purchase the shares, not the date your stock option was granted. This is important: You must exercise your stock options and hold your stock for a minimum of five years to qualify for QSBS treatment.
Not being aware of this seemingly small difference between stock and stock options could cost you a lot of money in tax.
Rule #5: You Can Exclude Up to $10 million in Gain. Yes, Really
How much money could overlooking the five-year rule cost you? A lot. The amount of taxable gain you can exclude from income is limited to the greater of:
An aggregate per taxpayer of $10 million; or,
10 times the cost basis of shares sold in the tax year.
Cost basis is what you paid for your shares; for example, the price you paid to acquire the shares when you exercised stock options. Typically, your cost basis will be small and the $10 million limit will apply.
Yes, you read that right: Up to $10 million of gain can be excluded from income tax for a married couple filing a joint tax return. And potentially even more can be excluded using advanced income tax planning techniques. In some cases, it’s possible to receive multiple $10 million gain exclusions using trusts and other related techniques.
The “$10 million or 10 times basis” rule applies per issuer, which means per company. If you’re holding stock in multiple companies, the maximum applies to each company.
Rule #6: When You Acquired the Stock Matters
Another important set of rules deal with when you acquired company stock. The breakdown:
The 100% gain exclusion applies to stock acquired after September 27, 2010.
For stock acquired between February 18, 2009, and September 27, 2010, 75% of gain is excluded from income.
For stock acquired between August 11, 1993, and February 17, 2009, 50% of gain is excluded from income.
No exclusion is available for stock acquired before August 11, 1993.
Final Thoughts on QSBS
The QSBS exclusion has been in federal tax law and available for more than 25 years. It became permanent in 2015 with the Protecting Americans from Tax Hikes Act (the PATH Act). In 2018, it received renewed attention after the Tax Cuts and Jobs Act permanently reduced the federal corporate tax rate to 21%, enhancing the attractiveness of C corporations.
Many states follow the federal tax treatment of QSBS (or don’t have a state income tax), but there are important exceptions. California, for one, does not offer a QSBS tax exclusion. Small business stock sales are fully taxable in California. Pennsylvania also does not offer a QSBS tax exclusion. Massachusetts, New Jersey, and Hawaii offer a QSBS exclusion with some modification to the federal requirements.
The QSBS income tax exclusion is an important consideration when deciding whether to exercise your stock options. The potential to not pay federal and state income tax on the gain when you sell your shares is obviously highly important.
Other factors to consider are how successful you expect the company to be and how this investment relates to your overall financial plan—you are deciding to invest in the company and should view an exercise of stock options in that context. The cost to exercise your options is another factor because you will pay cash now at the exercise price to buy shares but won’t be able to sell your shares for at least five years if you want to qualify for QSBS tax treatment.
The rules defining what stock qualifies for the QSBS tax exclusion are detailed and complicated. If you think you have stock that may be QSBS eligible, consider consulting with an experienced tax attorney, a certified public accountant (CPA), or a financial planner who is knowledgeable about QSBS. If your option shares don’t qualify for QSBS tax treatment, learn about taxation for non-qualified stock options and incentive stock options.
[1] https://www.law.cornell.edu/uscode/text/26/1202
