Qualified small business stock: Overview, definition, and example
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What is Qualified Small Business Stock (QSBS)?
Qualified Small Business Stock (QSBS) is a special type of stock issued by eligible U.S. startups that offers significant tax benefits to investors. If certain conditions are met, individuals who sell QSBS can exclude up to 100% of the capital gains from federal taxes. QSBS is defined under Section 1202 of the Internal Revenue Code.
Why is Qualified Small Business Stock (QSBS) important?
QSBS is a powerful incentive for early-stage investment. It encourages individuals to invest in small, growing businesses by offering the potential for tax-free gains after a holding period—typically five years. For founders, employees, and angel investors, QSBS can lead to substantial tax savings when exiting a successful company. It also affects how companies structure their financing and legal setup.
Understanding Qualified Small Business Stock (QSBS) through an example
If an angel investor buys $100,000 worth of QSBS in a qualifying startup and sells it five years later for $2 million, they may be able to exclude all $1.9 million in capital gains from federal taxes. However, this benefit only applies if the company meets strict criteria, such as being a C-corporation, having less than $50 million in assets at issuance, and using most assets in an active business.
Example of a Qualified Small Business Stock (QSBS) clause
Here’s how a Qualified Small Business Stock (QSBS) clause may appear in a contract:
"The Company shall use commercially reasonable efforts to comply with the requirements of Section 1202 of the Internal Revenue Code and to structure its operations in a manner that preserves the status of the Shares as Qualified Small Business Stock, provided that no representation or warranty is made regarding actual qualification."
Conclusion
Qualified Small Business Stock offers a major tax advantage for investors and plays a strategic role in startup financing. While the rules can be complex, planning around QSBS early can help founders and investors maximize long-term value. Businesses should consult tax advisors and structure equity thoughtfully to preserve QSBS eligibility where possible.