The Qualified Small Business Stock (QSBS) Tax Exemption and What California Business Owners Need to Know

Accessing capital and managing taxes are top priorities for any established or up-and-coming business owner, and Qualified Small Business Stock (QSBS) and its tax exemption may be a solution to achieve both goals. The QSBS tax exemption supports small business growth, helping attract investors to your company because of its appealing tax treatment of capital gains. Potential tax savings may also contribute toward long-term security as business owners plan for retirement. Let’s dive into QSBS, discussing why it could be tax-advantageous, and focusing on state-specific considerations for California business owners. 

What Is Qualified Small Business Stock?

QSBS is designed to support investments in small businesses, among other reasons, to drive economic development and job creation. Eligible small businesses may issue QSBS, or shares in their company, to raise capital or for other purposes in exchange for favorable federal tax treatment on capital gains if investors meet certain criteria, including:

• The investor must have purchased the stock directly from the issuing company after Aug. 10, 1993, to qualify for the tax benefits.
• Shareholders may be eligible to exclude 100% or a large portion of capital gains from their taxable income when they sell the stock or if the company sells, following a five-year holding period. 
• Specifically, investors may exclude whichever is greater annually: $10 million in gains or 10 times the adjusted cost basis (the amount initially paid for the stock). A 28% capital gains tax will apply to any gains over these amounts.
• A capital gain, or investor’s profit, is the difference in stock price between the issue date and the sale date. 

Example: Let’s say you purchased QSBS for $100,000 and held it for five years, at which time you sell it for $500,000. The capital gain in this case would be $400,000: sale price ˗ purchase price. With the QSBS tax exemption, you can exclude this gain from your taxable income, meaning you don’t have to pay federal capital gains tax on it. Depending on your tax rate, this could result in significant tax savings.

• Exemption rules may vary by state. For example, QSBS does not have state-level tax benefits in California. Still, California business owners can avoid federal taxation on their gains and potentially state taxation if their business operates in other states that permit the QSBS exemption.

Which Small Businesses Qualify for QSBS?

Only certain businesses are eligible to issue QSBS. If you meet the criteria outlined by the Internal Revenue Code (IRC), you may be eligible to issue QSBS:

• Company Structure: Companies must be structured as a domestic C corporation (C corp).
• Company Size: Gross assets must not exceed $50 million at the time of stock issuance or immediately after.
• Industry Type: The IRC excludes certain types of businesses from QSBS eligibility, including:
  • Professional services, such as law, accounting, and consulting
  • Banking, insurance, financing, leasing, investing, or similar businesses
  • Farming businesses
  • Businesses that produce or extract oil, natural gas, or other specified minerals
  • Hospitality businesses like hotels or restaurants
• Original Issuance: The qualified small business must issue the QSBS by purchase or as compensation. An investor cannot purchase it on a secondary market. 
• Active Business Requirement: At least 80% of the company’s assets must be used to conduct the qualified business.
• Holding Period: Investors must hold the stock for more than five years to qualify for the QSBS tax exemption.

What Are the Benefits of QSBS for Small Business Owners?

There are several reasons QSBS may be appealing to small business owners. 

• Federal Tax Exclusion: The primary benefit of QSBS is the potential exclusion of 100% or a large portion of capital gains from federal taxes if you hold the stock for more than five years (and meet other criteria). The significant tax savings allow investors to keep more of their profits.
• Tax-Efficient Investment Opportunity: Offering QSBS can make your business more attractive to potential investors, particularly those seeking a long-term investment. It may be an effective solution to raise capital to help your business lower costs, increase its value, or support growth efforts while providing investors with a tax incentive.
• Exit Strategy Planning: If you plan to sell your company or transfer ownership over time, the potential tax savings — and profits, if you hold stock as a business owner — from QSBS can help enhance your net proceeds from the sale and financial position, making the transition to retirement smoother.
• Vested Interest: When a business owner also holds QSBS, it can strengthen confidence among shareholders that everyone involved is committed to the company’s success.

What Do California Business Owners Need to Know About QSBS?

There are specific state-related considerations for QSBS for small business owners in California. 

• California Taxation: As we’ve mentioned, capital gains on the sale of QSBS in California are still subject to state income tax. Business owners can still exclude their capital gains from their federal taxes if they meet all criteria. 
• Reporting Compliance: Since California taxes QSBS gains at the state level, business owners must accurately report them on their tax returns to comply with state laws.
• Apportionment Rules: Apportionment is how a state allocates the taxable income of a business operating in multiple states. These rules give each state the right to tax the portion of income-generating activities within its borders. California has specific rules about the apportionment of income, meaning California business activities might be subject to state taxes while gains in other states might not be.
• C Corp Conversion: While not state-specific, pass-through companies, such as an LLC or S corp, can benefit from QSBS by converting to a C corp before a planned sale. Discussing the timing, legal requirements, and tax implications of a conversion with a professional is crucial to ensure an advantageous strategy.

Considering QSBS? How CCMI Can Help

When considering QSBS, a trusted partner can help you navigate the requirements, tax implications, strategies, and other complexities related to the tool. At CCMI, we specialize in assisting California business owners optimize their tax planning and exit strategies, which may be enhanced through QSBS. 

CCMI principal and owner Brian Matter is here to help if you need expert guidance. As a CERTIFIED FINANCIAL PLANNER™ professional, a Certified Private Wealth Advisor® designee, and a Certified Exit Planning Advisor, Brian offers invaluable expertise in helping business owners navigate their financial lives. His firsthand experience includes successfully transitioning into ownership at CCMI in 2017, uniquely positioning him to share insights with other business owners.

Please contact us to learn more about QSBS and whether it makes sense for your business.

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