Qualified Small Business Stock (QSBS): A Huge Tax Benefit

Article Highlights:

•  What is Qualified Small Business Stock (QSBS)?
•  What Stock Qualifies as QSBS?
•  The Tax Benefits of QSBS
• Maximum Exclusions and Updated Legislation under OBBBA
• Disqualifications and Special Cases
•  Transfers, Passthroughs, and Rollover Opportunities
•  Understanding Tax Rates and Exclusions
• Alternative Minimum Tax (AMT) and Electivity

Qualified Small company Stock (QSBS) provides a significant tax advantage for investors looking to support small company operations.  QSBS, which was introduced as part of the Revenue Reconciliation Act of 1993, allows investors to exclude a significant percentage of their capital gains from taxable income under Section 1202 of the Internal Revenue Code or roll the gain over into other QSBS.  This article delves into crucial aspects of QSBS, from its definition to its intricate tax treatments.

What is Qualified Small Business Stock (QSBS)? QSBS refers to shares of a C corporation that are eligible for the tax benefits stated in Section 1202.  Not every C company stock fulfills the criteria; specific requirements for issuing corporations, holding periods, and so on must be met.

What Stocks Qualify as QSBS? To be classified as QSBS, stock must be issued by a domestic C corporation that is actively engaged in a qualified trade or business.  The key qualifications include:

• Small Business Status: Prior to stock issuance, the corporation's gross assets cannot exceed $50 million ($75 million after July 4, 2025).
• Active activity Requirement: At least 80% of the corporation's assets must be actively used for the eligible trade or activity.
• Qualified Trade or Business: Excludes most service-oriented enterprises, including health, law, and financial services, farming, and hotel/restaurant operations.  The company should primarily participate in qualifying activities.

Tax Benefits of QSBS: One of the most appealing aspects of QSBS is the ability to exclude up to 100% of capital gains on the sale of such stock.  The exclusions for stock acquired have evolved as follows:

• Prior to 2009 revisions, capital gains were excluded at 50%.
• Prior to the 2010 Small Business Jobs Act, there was a 75% exclusion for amendments made after 2009.
• After the 2010 Small Business Jobs Act and before the OBBBA modification, stock acquired between September 28, 2010, and July 5, 2025 is 100% exempt.

Maximum Exclusions and Updated Legislation for OBBBA: The One Big Beautiful Bill Act (OBBBA), effective for stock acquired after July 4, 2025, added new exclusions:

• 50% for three-year holdings
• 75% of four-year holds.
• 100% for five-year holds.

For stocks purchased before July 5, 2025, the investor's excludable gain is limited to $10 million or ten times the taxpayer's adjusted basis in the QSBS, whichever is higher.  For stock acquired after July 4, 2025, the maximum rises to $15 million, plus subsequent inflation adjustments.

Disqualifications and Special Cases: Certain situations make stock ineligible for QSBS rewards.

• Disqualified Stock: Stock repurchased from the same corporation within 2 years.
• Entity status prevents S corporation shares from qualifying unless converted to C corporation status.

Transfer, Passthrough, and Rollover Opportunities

• QSBS can be transferred as a gift, with the recipient inheriting the holding period and potentially eligible for tax benefits.
•  Passthrough Entities: Partnerships and S companies can possess QSBS, with each partner potentially benefiting from exclusions if certain circumstances are met.
• The Gain Rollover Election under Section 1045 allows for the deferral of gains from the sale of QSBS held for over 6 months.  When this option is selected, the untaxed gain reduces the basis of the bought shares.  The QSBS gain exclusion can be applied later, once the replacement stock has been sold and held for the required number of years.

Understanding Tax Rates and Exclusions

Not all gains are excludable under Section 1202.  Additionally:

• Non-excludable QSBS gains are not eligible for 0%, 15%, or 20% capital gains rates, resulting in a maximum tax rate of 28%.

Alternative Minimum Tax (AMT) and Electivity - Exclusions from QSBS were previously considered an AMT preference item, but recent revisions have removed this consideration.  Treatment under Section 1202 is largely automatic if eligibility is established, with no specific elective procedure.

QSBS provides large tax breaks and promotes investment in domestic small enterprises.  Understanding the qualifications, advantages, and restrictions allows investors to better design their portfolios to take advantage of QSBS rules.

Staying informed and consulting with this office will help assure compliance and maximize tax benefits.