If you’re sitting on stock from a startup you joined early and wondering if there’s some magical tax rule that helps you avoid a massive bill when you finally cash out… good news: there is.
It’s called QSBS.
Let’s walk through how does QSBS work, what you need to qualify, and how to actually use the thing when tax time rolls around.
So… What Is QSBS?
QSBS stands for Qualified Small Business Stock, and it’s tucked into Section 1202 of the Internal Revenue Code. It’s one of those rare corners of the tax code that’s actually super generous.
If you qualify, you might be able to exclude up to $10 million or 10 times your basis (whichever is more) from capital gains when you sell your shares.
Yes, really. That’s up to $10 million tax-free.
The catch?
You’ve got to meet some criteria. More on that in a sec.
One thing to keep in mind: QSBS is a federal tax break, not a state one.
Some states follow along, some don’t. So when we talk about this benefit, we’re talking federal savings only.
Who Can Use QSBS?
There are a few rules. Here’s what needs to line up for your stock to qualify:
- You must not be a corporate investor. Meaning, no LLCs or corporations investing in another corporation and trying to claim this. You’ve got to be an individual or a trust.
- The company has to be a U.S.-based C Corporation. Not an S corp or a partnership. Also, it needs to be a domestic C corp, not based abroad.
- You must get the stock directly from the company. So if you buy your shares secondhand (like from a friend or another investor), they don’t count.
- You have to hold the stock for at least 5 years. And we mean exactly 5 years, not four years and 364 days.
- The company must have had less than $50 million in gross assets when you acquired the shares.
Why does the $50M cutoff matter? The IRS only considers companies with less than $50 million in gross assets as “small businesses.” Once they cross that line, they’re too big to qualify for QSBS. That’s why when you get your stock matters. Not sure if the company qualified when you joined? Just ask the CFO. Most startups already track this because it matters to a lot of employees.
- The company has to be using 80% of its assets to actually run the business. So if they’re just sitting on cash or investing in random stuff, that’s a red flag. They have to be using that money to build the thing they were founded to build.
- Certain business types are excluded. Think: health services, law, financial services, insurance, banking, investing, and leasing businesses.
But here’s where it gets interesting: tech companies adjacent to those categories can still qualify.
For example: if you’re building a health tech app that connects doctors and patients, that’s okay. You’re building software. You’re not providing the healthcare service itself.
The same goes for legal tech. If you’re building a platform to help law firms manage documents, that’s different from being a law firm.
Okay, Let’s Say I Qualify. How Do I Report It?
You’ll get a Form 1099 when you sell your shares. That goes on your Schedule D when you file taxes.
Then, you back up that Schedule D with Form 8949, where you apply the QSBS exclusion.
Here’s the thing: the exclusion is either $10 million or 10x your basis, whichever is greater. But the IRS doesn’t track how much of that you’ve used.
So if you sell in chunks over a few years, you need to keep your own record of how much exclusion you’ve used up.
No, seriously, track this yourself.
There’s no IRS form that keeps tabs on your QSBS exclusion total. If you sell your shares over time, or give some to family, you’re responsible for keeping a running total. We usually recommend a simple spreadsheet or Google Doc where you track:
- Date of each sale
- How much you sold for
- What your original basis was
- How much exclusion you’ve claimed so far
Trust us, future-you (or your accountant) will thank you.
So What’s the Tax Savings?
Normally, when you sell stock you’ve held for 5+ years, the capital gains tax is 20% on the gain.
That’s before any net investment income tax or other possible add-ons.
So if you bought stock for $100,000 and sell it years later for $5 million, that $4.9 million gain would normally be taxed at 20% (which is nearly $1 million in taxes).
With QSBS? You could exclude all of that.
Well, Can You Save Even More Than $10 Million?
You bet. There are advanced strategies called stacking and packing.
1. Stacking
This is where you gift shares to family members, typically kids, but it could also be siblings, parents, etc. before the sale.
Each person gets their own $10 million exclusion. So you’re effectively multiplying the exemption across your family.
We’ve helped clients do this at KB Financial Advisors. It’s a super powerful way to increase your tax-free gains.
2. Packing
This involves investing more money into the company to increase your basis. The higher your basis, the bigger your 10x exclusion could be.
For example, if you originally invested $1 million, your exclusion would be up to $10 million.
But if you invest more down the road and your basis becomes $2 million, your 10x exclusion could go up to $20 million, depending on how things play out.
If this feels complex, that’s because it is. But it’s doable, and we do it for our clients.
Want to Explore QSBS Further?
QSBS is one of the most generous tax breaks out there if you’re involved in a qualifying startup early on.
But the rules are specific, and tracking your eligibility (and how much of the exemption you’ve used) is on you.
That said, we help clients do this every day.
From simple $10M exclusions to advanced stacking and packing strategies, it’s one of our specialties.
Still have questions about whether your stock qualifies for QSBS, or want help planning ahead? Let’s talk!
At KB Financial Advisors, we’re always here to help. Simply head over to our contact page to book an introductory, casual chat.
Until next time!
