QSBS for Dummies

Understanding how QSBS works can be incredibly important to compound returns in early stage investing and we will explain how it works

Summary

At a high level, if you are not a corporation, and you invest in a qualified small business, you need not include a certain portion of gains as a part of income if you hold that position for at least 5 years

This document is written for people invested in non real estate and non oil and gas Qualified Small Business Stock (QSBS) companies.

First, identifying a qualified small business is not straightforward. Generally, for minority investors without atypical access to the company's financial and operating data, making the qualified business designation is likely to come in the form of a statement from the company, provided after an audit.

It is plausible, but not advisable, to read the rules below and make the determination yourself

A domestic C corporation which issued stock after 1993
- Not a REIT, REMIC, DISC or Regulated Investment COmpany.
The corporation remains a C corp for its entire life
Gross assets before issuance are <=50mm(including all subsidiaries with 80% ownership aggregated)
Gross assets after issuance are <=50mm
- Subsidiaries
  - are companies which the corp owns and controls >50% of assets
  - Subs assets are proportionally represented on the parents balance sheet
  - If at any point the corp owns more than 10% of its assets in a non subsidiary - the asset test is considered to have failed
- Working Capital
The company provides report to the shareholders stating the above facts
During the taxpayers holding period - the company must use 80 percent of assets to operate only in active businesses :
- Startup activities are covered
- R&D which is then used within 2 years for active business
- A business which is not providing the following services
  - Health
  - Law
  - Engineering
  - Architecture
  - Accounting
  - Actuarial science
  - Performing arts
  - Consulting
  - Athletics
  - Financial services
  - Brokerage
  - Or a service depending on the skill of employees alone
  - Banking
  - Insurance
  - Financing
  - Leasing
  - Investing or similar
  - Farming
  - Mining
  - Hotel / motel
  - Restaurant

Second, Stock must be bought at original issue in a Qualifying transaction and the gains are limited to the higher of either:

10mm USD - prior years eligible gains related to the issuer
10x the aggregate adjusted basis of the qsbs stock disposed of in the relevant tax year. The original basis must be based on the original issue date

Non Netting

Losses on one QSBS stock do not reduce the tax exemption on the gain. This means that losses in one QSBS asset can be written down against vanilla capital gains at the same time as gains from another being used via the exclusion from taxable capital gains at the federal level.

If you invest 1mm dollar , 100k of which are two qsbs investments of each 50k. After the investment period you have total capital gains of 2mm dollars. 500k from non qsbs investments and then 1.55mm dollars of gains from qsbs investment #1 and a 50k total loss from qsbs investment #2.

In this scenario your capital gains to record are 450k ( 500k less 50k capital loss).

All of 1.55mm in gains from QSBS investment 1 can be excluded from federal income taxes

Holding Period & Reinvestment

Holding periods does not include holding period of options or holding period of convertible debt prior to exercise.

Holding period for preferred shares converted to common stock are included in holding period

You may also within 60 days re-invest QSBS gains - here is how:

https://www.irs.gov/pub/irs-drop/rp98-48.pdf

QSBS Law timeline

1993 - Section 1202 Enacted - largely set out that 50% of all gains on Qualified small business stock could be excluded from income tax. The law also allowed for deferral of gain on sales within 5 years as long as proceeds were used to purchase “SSBIC” specialized small business investment companies - the stock of a small business, licensed with the small business administration even if the SSBIC only invested in the stock of other corporation, and not subject to the active business requirement.

1997 - Section 1045 Enacted - enables the rollover of gains to purchase other qualifying small business stocks within 60 days of the sale of the original stock as long as the target business meets the active business requirement for 6 months following purchase. Additionally, the investor may rollover after holding each stock for at least 6 months and The 5y period for the section 1202 exclusion remains.

2009 - American Recovery and Reinvestment Tax Act passed - enabling a 75% exclusion for stocks purchased after feb 7 2009.

2010 - 100% for stocks purchased after 2010