How to Apply for QSBS

At year-end, we receive a lot of questions on Qualified Small Business Stock (“QSBS”).  One of the recurring questions we hear is, “How do I apply for the QSBS?”. The answer: You don’t! Instead, a founder or investor’s stock qualifies for QSBS. If you’re in the startup space it’s important to understand the tax benefits it creates and how to qualify.

Typically, venture investments are charged capital gains tax when you sell or exit the investment. The tax rate on capital gains held more than one year are either 15% or 20%, depending on your income level. The purpose of lower rates is to encourage capital investment by charging less tax than ordinary income tax rates. For qualified small businesses, there is an even greater incentive. QSBS allows for 0% tax upon exit for the first $10 million of gains or up to 10x the investment. That’s right – there’s potential to pay no tax at all!

For founders and investors, zero or limited tax impact provides you with just one more reason to invest in tomorrow’s startups; when they grow, your tax bill doesn’t necessarily have to. Like a lot of tax topics this stuff can feel complicated, but it doesn’t have to be. To make it easy, we put together the below table to help you understand what qualifies as QSBS and what doesn’t:

Qualifies	Doesn’t Qualify
US domiciled C-Corporation Stock (Stock issued after August 10, 1993)	Partnership interests, S-Corporation shares, Foreign Corporation Stock, Stock issued prior to August 10, 1993
Technology, Retail, Wholesale or Manufacturing businesses	Service industry businesses (hospitality, personal services, financial services, farming, mining)
Stock acquired directly from the Qualified Small Business itself for money, property, or services	Stock purchased from a third party, like an existing investor
Tax Basis of Qualified Small Business is $50 million or less	Tax Basis greater than $50 million
Shareholder holds the qualified shares for at least five years	Shareholder exits prior to the five-year holding period
80% or more of the Qualified Small Business’s assets must be used toward the operation of the qualified business	More than 20% of the Qualified Small Business’s assets are used for a non-qualified operation

Again, we want to reiterate that there is no application process, simply a qualification. That being said, there are some steps you should consider when organizing your business or making an investment in a smaller company. The below table illustrates a few of the pitfalls you should be aware of in order to make sure you avoid missteps when building or investing in QSBS opportunities:

Pitfalls	Example
NAICS Code Mismatch	Your NAICS Code (used to identify your business’s industry) doesn’t match an industry qualified for QSBS. For example, you may be building a tech startup but the NAICS code on your taxes says you’re a hotel.
State Non-Recognition	California, along with a few other states, don’t conform to the federal treatment of QSBS
The Gross-Asset Test Failure	Holding too much cash on the balance sheet, or other non-qualified assets can disqualify QSBS holders
Redemptions and Recapitalizations	It’s important to know when recapitalization occurs, or when related persons (siblings, spouses, etc.) redeem their stock in order to determine your current QSBS compliance status

We wouldn’t be named Calculate if we left you with a bunch of qualitative information and no numbers though, would we? Here are some easy numbers to illustrate:

• You invest $500,000 in a QSBS (And of course you made sure it qualified before investing)

• Five years pass…

• The QSBS has done exceptionally well, and you can now sell your investment for $15 million. Your gain on the transaction is $14.5 million ($15 million of proceeds less your basis of $500,000).

• Of the $14.5 million of gains, $10 million will be excluded from capital gains tax (the greater of $10 million or 10 x $500,000). The remaining $4.5 million is subject to capital gains tax.

One more table!

Qualification	Taxable Gain	Tax Liability (@ 20% Tax)
QSBS	$4.5 million	$900,000
No QSBS	$14.5 million	$2.9 million

The above example, assuming a 20% capital gains rate, would yield a $900,000 tax bill as Qualified Small Business Stock. If we fail to qualify for QSBS, the liability would be $2.9 million. You can use that $2 million of tax savings to invest in more QSBS!

The benefits of investing in QSBS are obvious, but compliance with the rules is necessary to receive the treatment. We encourage you to be diligent with record-keeping when it comes to QSBS. Despite there being no application process for qualification, there are a number of disqualifying factors, and some common pitfalls that investors and business owners are unaware of. But if you’re looking for an excellent way to reward shareholders, and you’ve done your homework in order to comply with the rules, QSBS can allow founders and investors some significant tax advantages.

This article was written by Brandon Bohl.