Understanding Qualified Small Business Stock (QSBS) and Its Benefits

Qualified Small Business Stock (QSBS) under Section 1202 of the Internal Revenue Code (the “Code”) offers significant tax advantages to non-corporate taxpayers. If held for a stipulated minimum duration, eligible taxpayers can potentially exclude a portion or even all of the capital gains from the sale of QSBS. With a recent enhancement from the One Big Beautiful Bill Act (OBBBA), enacted on July 4, 2025, these benefits have been broadened, making investing in small businesses even more appealing.

What is QSBS?

QSBS is designed with one primary goal in mind: to encourage investments in small businesses. This exclusion can significantly benefit founders, early investors, angel investors, and employees who receive stock in qualifying companies. However, the rules governing QSBS are complex, and compliance is crucial to maintain its favorable tax status.

Key Requirements for QSBS Eligibility

To ensure that your stock qualifies as QSBS, you must meet several critical requirements:

1. Domestic C Corporation

• The business must be structured as a U.S. C corporation.

2. Gross Asset Limitation

• The corporation’s aggregate gross assets must not exceed $50 million at any time from August 10, 1993, until immediately after stock issuance. Following the OBBBA, this cap has been raised to $75 million, effective after July 4, 2025, with adjustments for inflation commencing in 2027.

3. Active Business Requirement

• At least 80% of the corporation’s assets must be used in an active trade or business for the duration of the taxpayer’s holding period.

4. Qualified Trade or Business

• The business must operate in active sectors, excluding certain fields like finance, professional services, and hospitality.

5. Original Issuance of Stock

• Shares must be obtained directly from the corporation at the time they were originally issued, although specific exceptions exist.

6. Capital Gain Exclusion

• Investors can exclude up to $10 million of capital gain (or 10 times their adjusted basis, whichever is higher) from taxable income for stock issued before July 4, 2025. After this date, the cap increases to $15 million.

7. Holding Period

• Stocks issued before July 4, 2025 must be held for at least five years to qualify for a full gain exclusion. For stocks issued afterward, the gain exclusions are tiered—50% after three years, 75% after four years, and 100% after five years.

Transferring QSBS Shares to Heirs and Trusts

One of the attractive features of QSBS is that the capital gain exclusion can be passed on to heirs or trusts. Section 1202(h) ensures that transferees inherit the same holding period advantages as the original owner.

Gifting QSBS

Gifting QSBS while the company is valued low can minimize gift tax implications and maximize future exclusion benefits. Moreover, transferring QSBS to family trusts can further optimize tax planning strategies. By distributing QSBS among multiple family members or irrevocable non-grantor trusts, it’s possible for each recipient to independently qualify for the exclusion, effectively increasing the tax-benefit scale.

Important Consideration: Establishing multiple non-grantor trusts requires careful planning. The IRS may aggregate trusts for tax purposes if they share the same grantor and beneficiary, especially if their primary purpose is tax avoidance. To mitigate this risk, it is advisable to assign unique trustees and terms for each trust.

QSBS in Mergers and Acquisitions

The QSBS status can still be maintained during mergers and acquisitions with proper planning. Under Section 351 and Section 368 of the Code, stock can retain its QSBS status in certain reorganizations, ensuring that shareholders can continue to benefit from the exclusions as long as holding periods are respected.

Conclusion

The enhancements brought by the July 4, 2025, OBBBA make QSBS a valuable tool for family estate planning, especially when leveraging the tax-free gain across multiple recipients. However, the intricate nature of these regulations necessitates cautious planning. Before engaging in any transactions involving QSBS, it is paramount to consult with tax and estate planning professionals to ensure compliance and to maximize the beneficial outcomes.

Final Thoughts

By taking full advantage of QSBS benefits, businesses and investors alike can foster economic growth while enjoying substantial tax relief. Understanding the nuances of QSBS is essential for achieving long-term financial success.

For tailored guidance, consult your estate and tax planning advisor to strategize effectively in the context of QSBS.