Financial Glossary
Qualified Small Business Stock (QSBS)
Qualified small business stock (QSBS) refers to shares of a domestic C-corporation that meet specific criteria under Section 1202 of the Internal Revenue Code, potentially allowing investors and founders to exclude a substantial portion of capital gains from federal income tax if the stock is held for more than five years. To qualify, the corporation must be a domestic C-corp engaged in a qualified trade or business (certain industries including financial services, hospitality, and professional services are excluded), and its gross assets must not exceed a defined threshold at the time the stock is issued. Shares must be acquired at original issuance in exchange for money, property, or services -- not purchased on the secondary market.
Problem & Application
An angel investor puts $500,000 into a SaaS startup's seed round, acquiring QSBS-eligible shares. Five years later the investor sells for $3,000,000, generating a $2,500,000 gain. Under Section 1202, the exclusion applies up to the greater of $10 million or 10 times the adjusted basis per taxpayer, so the entire $2,500,000 gain may be excluded from federal tax -- potentially saving over $500,000 compared to long-term capital gains treatment. Founders who receive QSBS at incorporation can also benefit if their shares qualify. Startups should confirm QSBS eligibility early (industry type, corporate structure, asset ceiling) and document issuances properly, since retroactive correction is often impossible. Note that state tax treatment of QSBS exclusions varies and some states do not conform to the federal exclusion.
In Short
QSBS is a valuable incentive for investors in small businesses, providing tax breaks that can enhance investment returns.