The Ultimate Qualified Small Business Stock (QSBS) Checklist for Startups and Their Investors

Section 1202 of the Internal Revenue Code can be a game-changer for startup founders and investors. It allows for a 100% exclusion from U.S. federal income tax on gains from the sale of qualifying small business stock (“QSBS”), with certain limitations, provided the stock has been held for at least five years. In practical terms, this means no federal capital gains tax on your stock sale gains, up to $10 million or 10 times your adjusted tax basis, whichever is greater.

For instance, if you're a founder who obtained stock at virtually no cost and later sell it for $25 million, your tax basis is near zero, setting your exclusion limit at $10 million. Therefore, you would only pay capital gains tax on the remaining $15 million. If the capital gains tax rate is 20%, your tax would be $3 million — a substantial saving from what would have been a $5 million tax bill without the QSBS exclusion. Certain states such as California have not adopted QSBS so you may still owe state income taxes on the full amount. With some advanced planning it may be possible to “stack” multiple $10 million exemptions or to take advantage of the 10 times basis rule.

The most common pitfalls that could cause you to lose QSBS benefits are repurchases and redemption of stock by the corporation. Investors frequently request various representations regarding the QSBS eligibility of the company’s stock during the company’s priced equity rounds (usually series seed and Series A).

Below is a checklist to help a stockholder (“Taxpayer”) conduct a preliminary audit of the stock’s status, but it’s not exhaustive, and consulting with a tax lawyer is highly recommended. Given the significance of these benefits, I strongly advise working with a tax lawyer; I work with Daniel Cousineau.

QSBS CHECKLIST

If you answered “No” to any of the questions below, you might have a QSBS issue.

1. Was the stock first issued after August 10, 1993? Stock obtained through conversion  from an LLC to a C corporation is treated as the issuance of new stock.
2. Has the company been a domestic C corporation during the entire time the Taxpayer held the stock?
3. Has the company been an eligible corporation for nearly all of the Taxpayer’s holding period? An eligible corporation means any domestic corporation but does not include:some text
   • Domestic international sales corporations ("DISC");
   • Regulated investment companies, real estate investment trusts, real estate mortgage investment conduits, or financial asset securitization investment trusts; or
   • Cooperatives.
4. Did the Taxpayer obtain the stock directly from the company when initially issued (either directly or via an underwriter), through:some text
   • purchase with money or in exchange for other property (excluding stock), or
   • receipt as compensation for services rendered to the corporation, except for services as an underwriter of the stock?
5. At least one of the conditions 5(a) or 5(b) below must be met:some text
   • The company has been recognized as a specialized small business investment company, licensed under Section 301(d) of the Small Business Investment Act of 1958 (as it was on May 13, 1993), for nearly the entire duration that the Taxpayer held the stock.
   • The company has met the active business requirement during the Taxpayer's holding period for the stock (the "Active Business Test"). To pass the Active Business Test, the company should be involved in one or more qualified trades or businesses. A "qualified trade or business" is any trade or business except for:some text
     • any trade or business mainly involving the performance of services in sectors such as health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any business where the primary asset is the reputation or skill of one or more of its employees;
     • banking, insurance, financing, leasing, investing, or similar business;
     • farming business (including tree farming);
     • any business that involves the production or extraction of products for which a deduction is available under Section 613 or 613A (i.e., natural resources production or extraction); and
     • businesses operating hotels, motels, restaurants, or similar.
   • 
     Furthermore, the company must actively use at least 80% (by value) of its assets in conducting one or more qualified trades or businesses. Cash and investments can be counted towards this 80% if they meet certain conditions:some text
     • they are held for the reasonable working capital needs of a qualified trade or business, or
     • they are held for investment and are reasonably expected to be used within two years to finance research and experimentation in a qualified trade or business or increases in working capital needs of a qualified trade or business (such assets defined as "Working Capital") shall be treated as used in the active conduct of a qualified trade or business.*
       
   • *Note for startups: if starting two years after the company was formed, if more than half of the company's total assets are in cash or investments, then that excess portion won't be considered as being actively used in the company's day-to-day business operations. In other words, when new cash comes in, for the first two years, 100% of that cash is considered a 'good' asset (working capital) that counts towards the active trade or business requirement. After that initial two-year period, for the next two years, only 50% of that cash is considered a 'good' asset that contributes to the active trade or business requirement.
     
     For example, let’s say a company raises $20 million. For the first two years, this $20 million is counted towards determining if at least 80% of the company’s assets are used in an active trade or business. In years 3-4, only $10 million of this would count as good working capital. If the company’s total assets are valued at $100 million during this time, $90 million would be considered 'good' and $10 million 'bad', so they would still meet the 80% requirement. However, if the company's total valuation is less than $50 million, then the $10 million of cash would be a bad asset, and they might not meet the 80% test.
     
     It’s important to deploy the cash within this timeframe, and it is worthwhile to keep track of this usage.
6. For a startup to keep QSBS tax benefits, it needs to actively use at least 80% of its assets in its business. Here's how the rules apply:some text
   • First Two Years: All cash raised counts fully towards this 80% active use requirement.
   • Years Three to Four: Only 50% of any remaining cash counts towards active use.
7. Example: If a startup raises $20 million:some text
   • First Two Years: All $20 million is considered active.
   • Years Three to Four: Only $10 million of the initial $20 million counts as active. If the startup's total assets are worth $100 million during this time, $90 million needs to be active to pass the 80% test. They meet the requirement since $80 million of other assets plus the $10 million from cash are active. If the total assets are only $50 million, then not enough of the company’s assets are active, risking their QSBS eligibility.
8. Essentially, the startup has a few years to effectively use or invest its cash in business operations to ensure it meets the QSBS requirements.some text
   • The company will not meet the Active Business Test during any period when:some text
     • more than 10% of its assets’ value, after deducting liabilities, is in stocks or securities in other corporations that are not its subsidiaries, except for stocks and securities that are considered Working Capital; or
     • over 10% of its assets’ value is in real property not used in the active conduct of a qualified trade or business.
9. BOTH of the following statements are true:some text
   • The company hasn't (and doesn't intend to) purchase more than a de minimis amount of its stock from the Taxpayer or any related person during the four-year period starting two years before the stock was issued. Any purchases made from the Taxpayer or related persons that total either (i) 2% or less of the Taxpayer's and related persons’ held stock, or (ii) $10,000 or less, are considered negligible.
   • Furthermore, the company has not engaged in, nor does it plan to engage in, purchasing its stock during the two-year period starting one year before the issuance of the stock if the total value of such purchases at the time they are made exceeds 5% of the total value of all its stock at the start of that two-year period. However, purchases by the company of its stock that do not exceed (i) 2% of the total outstanding stock at the time of purchase or (ii) $10,000 are considered de minimis.
     When considering this question, the following are not considered "purchases":some text
     • The company's buyback of stock from a seller who acquired the stock through service as an employee or director of the company, when this is connected to the seller's retirement or a genuine termination of such services;
     • The transfer of stock from a shareholder of the company to an employee or independent contractor (or their beneficiary), even if it is considered that the stock was first transferred to the company as per the relevant Treasury Regulations;
     • The company's acquisition of stock from the estate, beneficiary, heir, surviving joint tenant, spouse, or a trust of a deceased person (or their spouse), if the purchase takes place within three years and nine months following the person's death;
     • The purchase of stock due to the seller's disability or mental incompetence;
     • The acquisition of stock related to the divorce of the selling shareholder, as defined in the appropriate tax regulation section.
10. Throughout the period starting on August 10, 1993, and ending just after the stock was issued, did the company (or any predecessor) maintain cash and the total tax basis of all other assets at $50M or less at all times?

THANKS

Special thanks to Daniel Cousineau for helping to review this blog post.

DISCLAIMER:

This blog post is not legal or tax advice. I'm a corporate lawyer, but not your lawyer (yet), and I will never be your tax lawyer.

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