Qualified small business stock: Overview, definition, and example
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.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.