The Complete Guide to Qualified Small Business Stock (QSBS)

Investing in startups is exciting. It’s about encouraging innovation, generating employment, getting a chance to hit a financial homerun. However, you may not know that there is an added bonus to startup investing through taxation. Now it has a name – qualified small business stock or QSBS for short. Perhaps you don’t know it well enough? Well, here is the guide on how it works. 

We’ll summarise all the basics you should know about QSBS, along with the ways in which it assists you to make the most out of your investment. You will know everything there is to know about QSBS, what it can do for you, and how you can use it to earn more and pay less in taxes. This knowledge can definitely be a turning point for angel investors and those who fund the creation of startups. The more you know, the better you are able to set up your investments in order to create the greatest amount of profit.

What Is QSBS?

Let’s answer this question first: what is QSBS? Well, qualified small business stock is a special kind of investment. It is aimed at providing rewards to those individuals who step out for high risks while investing in startups. If you own QSBS for at least five years, then you can exempt from federal taxes a large portion of your capital gains. This is referred to as the qualified small business stock exclusion.

In a nutshell, QSBS is a tax incentive program designed specifically as an 'investor stimulus’ for start-ups. In essence, it is Uncle Sam’s (in the United States) way of telling the public ‘Thank You,’ for supporting small businesses endeavors. It stimulates both investors and local entrepreneurs since more attractive conditions are provided for small enterprises. The result? Additional funding for startups which will lead to more innovation, a healthy entrepreneurial environment. This is a necessary incentive to stimulate the advancement in economy and technologies while benefiting both investors and companies.

How Does QSBS Work?

Here’s a quick rundown:

1. You invest in a promising small business.
   
   

• It must be a U.S. company.
• It cannot own gross assets of over $50 million when you invest in the business.
• It can only operate in specific sectors of the economy (no banking, legal nor hospitality industry).
• The business entity concerned must be carrying on operations, which simply means it cannot be an investment company.
• The IRS has specific guidelines on what can qualify, so it is advised that a tax consultant be sought before the investor assumes that their investment is eligible for QSBS.
  
  

2. You acquire stock from the company itself.
   
   

• QSBS only works if you purchase the stock from the business directly. Publicly traded shares don’t count.
• This means that you need to buy shares in the company in the early stages of their funding rather than buying shares on a secondary platform.
• The direct stock issuance conditionality guarantees that QSBS advantages reach only those distinct parties who fund emergent ventures at crucial inception phases.

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3. You have to keep the stock for five years.
   
   

• Patience pays off! The rule of five years is crucial when it comes to realising the saving on taxes.
• If you sell before five years, the IRS may deny you the full qualified small business stock exclusion to which you are entitled.
  
  

4. You sell the stock and enjoy the exclusion.
   
   

• When you sell, you can exclude up to 100 percent of your capital gains. This exclusion is limited to the greater of $10 million or ten times your investment.
• This means that whereas you can invest $1 million, you can exclude up to $10 million in gains, hence saving a lot of money in taxes.
• Learning the art of when to sell is equally crucial since it determines your benefits that may be reinvested in future prospects. Therefore it is important to keep track of when you made the investment to qualify for the five year period.

Why Is QSBS Important for Angel Investors?

If you’ve been aware of angel investment, you know the value of investing in startups. But qualified small business stock takes it to another level. Here’s why:

• Tax savings: Taking out up to $10 million in capital gains (or more) is a game changer. That is the cash that you can immediately spend or roll on to the next round or use in any way you desire. Suppose you could sell a successful startup investment and take home all your profits tax-free – this is kind of rocket fuel to your investment plan. It frees up more capital for reinvestments and also allows you to explore more startups to invest in to further diversify and spread the risk.

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• Encourages risk-taking: Startups are risky. Similarly to QSBS, which shields you by minimizing the tax rate of your gains. For example, if you stand to make large profits that do not need to be taxed, you may be willing to take what you consider calculated risks on promising companies. The idea of receiving a tax deduction at some later date makes taking additional risks more appealing.
  
  
• Promotes innovation: When you patronize small-scale enterprises, you are contributing towards development of new products, growth of the economy. Increased capital in the startup will translate to increased start-up ideas, unique technologies, and employment opportunities. Successful startup ecosystem contributes to a stronger economy and improved lives of the next generations.

The Risks of QSBS Investing

Any investment comes with some level of risk; the same applies to QSBS. Startups are often unstable, and although the tax incentives are rather favorable, this does not mean that an entrepreneur will succeed. They could lose the business and little or no money would be generated from the investment and returned to the investor. Other issues such as the current state of the market, or changes in regulations also influence your odds of exiting at your desired valuation. As much as possible, it is unwise to invest mainly in qualified small business stock  with the expectation of returns on all investments. Furthermore, in some cases, tax laws may change and other successive governments may change or repeal QSBS benefits. It’s advisable to stay updated and consult with financial and legal experts concerning the existing and/or likely risks that you may encounter and to help you get the most from your investments.

Moreover, qualified small business stock is conditional in many ways, so even a minor mistake in paperwork or failure to meet certain requirements can cost your investment QSBS tax exemptions. For others, it is crucial to make sure that the startup you are investing in has not done things that put them on the account of the QSBS rules during the holding period. For instance, a company manager may fail to notice some slight changes within the company structure or the growth of some assets over a certain limit of $50 million – resulting in high taxes being imposed on the value added. These are risks that it is crucial to avoid and as long as one remains as active as possible and works with experienced tax consultants and practitioners, you should not miss some of these exemptions.

How to Incorporate QSBS into Your Investment Strategy

QSBS should not be your only goal but it should be a part of a strategic plan for your business. It is advisable to invest in more than one start up in order to reduce risk on individual investments. Further, look at criteria that indicate that a company is in the favourable place in the market by having strong leadership and management, having a business model that can be expanded and being in an industry that will have above average growth rates. Talk to founders, and due diligence teams, to confirm that the business fulfills qualified small business stock standards before investing. Timing is important—The longer you hold the investment for, the more tax shield advantages you will gain, which is usually at least five years from investment. If you’re within a few years of taking distributions, it is recommended you talk with tax advisors on ways to defer or re-invest in IRA’s rolling over while maintaining the tax advantages. A proactive approach in choosing startups and applying a diversified strategy will make it possible to maximize QSBS benefits.

The idea is to diversify your qualified small business stock  investments with other classes of investments, such as real estate investments, bonds or large capital stocks among others. However, though QSBS can present a tax advantage, it doesn’t guarantee investors a risk-free opportunity. It is recommended QSBS exempt gains be reinvested into new qualified small businesses in order to maintain tax efficient status of the portfolio. Through constantly reinvesting your gains into new qualified small business stock eligible startups, you can construct a perpetual, tax-favored wealth-building plan all while stimulating the entrepreneurial economy.

Final Thoughts

Qualified small business stock doesn’t only mean investing in companies – it means investing in the future of the world. So, the next time you’re reviewing a deal, ask yourself: Does this qualify as QSBS? If it does, you have one of the biggest tax incentives offered to investors at hand.

So, with the right planning and investing you can see that QSBS can be a real game changing factor in your portfolio. Do not let this pass you by, take the time to learn about it, speak with a professional, and take full advantage of such a tax break.

Want to learn more? Join the Venture Fundamentals course by Angel School to learn all about angel investing. Good luck with your QSBS investments; hopefully each investment in your QSBS will grow beyond your imagination.