Many small businesses have never heard of Qualified Small Business Stock (QSBS); and it’s a term that investors and entrepreneurs should know more about. To put it simply: when both the investor and the company meet certain requirements, this advantageous structure shields the investor from capital gains taxes after a holding period – making an investment in a business all the more alluring

QSBS benefits active, small businesses, that are domestic C corporations with gross assets that do not exceed $50 million on or immediately after it issues stock. We are seeing more and more tech startups utilizing Regulation A as their fundraising vehicle to reach everyday investors. Understanding the advantages of and how to navigate QSBs is essential for those looking to build a portfolio of budding tech startups and arm themselves with the right information that will allow them to capitalize on little known tax benefits.

How to Meet QSBS Requirements

More on the tax value of this unassuming stock: capital gains from QSBs are tax-free under Section 1202 of the Internal Revenue Code. However, there are a few rules/requirements investors need to meet before they can reap the tax benefits of this type of investment. For example, investors must have purchased the stock with cash or property at the time of issue, or received it as payment, and they must keep it for at least five years to qualify for the full capital gains tax exemption. At least 80% of the funds of the issuing company must be used in one or more of the eligible trades or companies.

Since there are different applications and exceptions, it’s always important to consult with your trusted tax advisor to ensure that you and any future investments meet all requirements. If a sale of shares occurs during the five-year minimum window, for example, you can also apply if you reinvest in another qualifying small company. This is known as a 1045 rollover. This strategy helps you to keep your QSBS eligibility if your cumulative holding time is shorter than five years. Despite the shift of investment, the QSBS exemption will be maintained if you handle it as if you kept one investment for a five-year period.

The Biggest Benefit: No Capital Gains Tax

If holders of small business stock satisfy the conditions, they will be entitled to withhold up to 100% of the profits on the disposal of stocks. Per shareholder, there is also a cap of $10 million or 10 times the basis of QSB stock, whichever is greater. The extent of tax benefits will, of course, differ from one investor to the other, and will be determined by where the stock was purchased and how long it was kept.

The ability to deduct 100 percent of a gain on the selling of stock is nearly unrivaled, but many people are unaware of Section 1202, in which capital gains from QSBS are partly or wholly exempt from federal taxes. The government has increased the amount that can be excluded to this possible exclusion since the 1990s, but even with those increases, this advantage went relatively unnoticed for years, owing to a lack of understanding. The initial 50% exclusion was increased to 75% for those purchased between February 18, 2009 and September 27, 2010, and then to 100% for those purchased on or after September 28, 2010. As an extra bonus, unlike many other tax cuts, this 100% deduction is indefinite.

Startups (Q)ualify as (S)mall (B)usinesses

Investors should keep an eye out for QSBS offerings to see if they are able to take advantage of Section 1202’s impressive potential. The overarching lesson is that nontraditional investments will often have added benefit. Reg A offers in sectors like tech, for example, are becoming more common, and many of them qualify as QSBs, allowing qualified investors to benefit from the tax benefits. These QSBS tax incentives are particularly tempting now, considering Biden’s new tax reform proposal, which seeks to lift capital gains taxes. While more conventional investments are great, it’s important to keep an eye out for these nontraditional investing opportunities that help small businesses.

While more conventional investments are fantastic, it’s important to keep an eye out for these nontraditional investing opportunities that benefit investors. Many investors have come to the realization that access to entrepreneurial startup companies should be an important part of their overall portfolio mix. Investors really need to know about QSBS exclusion. If they’re not investing in venture capital in this way, not only are they missing out on essential appreciation in the private market, but they’re also missing out on some significant tax breaks.

Steven Weinstein is the CEO of Seismic Capital Company, an early-stage growth investor committed to identifying, guiding, and nurturing companies seeking to meaningfully disrupt the space they work in. Steven has been involved in the capital markets, financing, private equity, venture capital and real estate over the past 30 years. Since 2002, he has been the Managing Director of Marketmaker Capital where he managed numerous transactions, capital structures and projects ranging from real estate advisory, loan portfolio structures and private equity funding.

Investment stock photo by fizkes/Shutterstock