Given how complex the idea of Qualified Small Business Stock (QSBS) is, it’s not surprising anymore that founders, investors, and others frequently ask questions concerning it.
Questions must be outlined as guidelines to fully understand the concept of QSBS.
With that, let us give you a high-level overview of QSBS in this article by answering questions frequently asked by people.
Frequently Asked Questions About Qualified Small Business Stock (QSBS)
What types of businesses can be eligible for QSBS?
A “qualified trade or business” is defined by Section 1202(e)(3) as any enterprise other than:
- Any trade or business where the principal asset is the reputation or skill of one or more of its employees, including the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services
- Any activity related to banking, insurance, financing, leasing, or investing
- Any farming enterprise
- Any enterprise engaged in the creation or extraction of goods, like mining
- Any enterprise that runs a hotel, motel, restaurant, or another comparable enterprise
Although the word “performance of services” is ambiguous and evaluating whether a company’s “principal asset” is a particular employee’s competence or reputation can be unclear, the IRS has provided some clarity in several case rulings.
When should I consider QSBS?
You should consider QSBS if you are an investor who is interested in investing in small businesses that meet the requirements for QSBS status. QSBS can provide significant tax benefits to investors if certain conditions are met, including holding the stock for at least five years.
How do I get QSBS stock?
To get QSBS stock, you need to invest in a qualified small business that meets the requirements for QSBS status. To be eligible for QSBS status, your small business must be a domestic C corporation, and its gross assets must be $50 million or less at the time of the stock issuance. The stock must also have been issued after August 10, 1993, and you must hold the stock for at least five years for it to fully qualify for the exemption.
Can I lose my QSBS stock?
Yes, just like any other investment, QSBS stock carries a risk of loss. The tax benefits of QSBS only apply if you hold the stock for at least five years, and if you sell the stock before that time, you may lose those benefits. Additionally, the value of the stock may go down, resulting in a loss on your investment.
When do I know that QSBS no longer applies?
When the company’s gross assets reach $50 million or more right after the round’s closure, you’ll know that QSBS is no longer relevant to the shares issued in the financing. Therefore, QSBS will not be applicable if you are financing more than $50 million.
Can QSBS benefits be applied to stock options?
No, stock options like ISOs and NSOs are not eligible for QSBS benefits. Before the shares of an employee’s company can qualify for the QSBS, the employee must first execute their option and purchase the shares.
Can QSBS benefits be applied to investments in non-US companies?
No, only investments in US-based C corporations that meet specific requirements outlined in Internal Revenue Code (IRC) Section 1202 can qualify for QSBS advantages.
How are QSBS shares taxed?
QSBS shares can be taxed at a lower rate than other types of stock if certain conditions are met. If you hold QSBS for at least five years and meet the other requirements for QSBS status, you may be eligible for a federal tax exclusion of up to 100% of the gain on the sale of the stock, up to a maximum of $10 million or 10 times your basis in the stock (whichever is greater).
How do I transfer QSBS from one company to another?
If you recently sold your QSBS for a realized gain before the expiration of the five-year holding period, you might want to use the Section 1045 rollover. You have 60 days after the stock is sold to reinvest the earnings from the sale into one or more newly issued QSB stocks.
Can I qualify for QSBS by owning shares in the corporation through an LLC, S corporation, individual, or another business?
Yes, you can qualify for QSBS benefits if you own shares through any entity except a C corporation. Eligible shareholders for QSBS include individuals, trusts, estates, partnerships, LLCs (taxed as a partnership or single-member), and S corporations under Section 1202.
This means that you can invest in QSBS directly as an individual or through an eligible pass-through entity.
However, to qualify for beneficial QSBS treatment, non-corporate owners of pass-through entities must fulfill additional requirements specific to their situation.
Among other requirements, partners need to report their share of the QSBS gain based on their proportionate ownership in the partnership’s adjusted basis in the QSBS on their individual tax returns.
Furthermore, according to regulations under Section 1045 (which governs the rollover of QSBS), if you are only the holder of a carried interest, it cannot qualify for the purposes of that statute. The regulations specifically refer to a partner’s capital, and a carried interest represents a share of partnership profits rather than capital.
Other than forming the right entity and satisfying the general requirements, do I need to make any special filings or elections?
There is no specific filing or election required to claim Qualified Small Business Stock (QSBS) benefits, other than meeting the general requirements, such as forming the right entity and holding the stock for at least 5 years.
QSBS is automatically available to eligible C corporations, and there is no separate election or filing needed to claim the potential capital gains tax exclusions provided by QSBS.
However, it is still important to keep proper documentation and records to support your claim of QSBS, as these may be needed in the case of an IRS audit or other verification processes.
Where do I list the QSBS exclusion?
Depending on the year the stock was acquired, QSBS exclusions are listed on different tax forms. Form 8949, Schedule D, Form 1045, Form 6251 (if acquired prior to September 27, 2010), and Form 8960 (if a portion of the gain is not excludable) are some of these documents.
What is the process for claiming QSBS benefits on tax returns?
Shareholders must make sure that both the issuing corporation and the shareholder satisfy the QSBS eligibility standards in order to collect QSBS benefits. They must then figure out the exclusion amount, include the transaction in their tax returns, and keep all necessary records and paperwork to support their QSBS status in the event of an IRS audit.
Final Thoughts
We want to reiterate that QSBS is a complicated concept. There is a lot of information that needs to be discussed and understood thoroughly.
When trying to optimize for QSBS treatment, you should always seek advice from legal professionals, as there are myriad traps for the unwary.
Always remember that it’s difficult to undo actions that have already been taken.
With guidance from Compass CPA PC, you can have the assurance that you get it right the first time!
