Qualified Small Business Stock: What Is It and How to Use It

Imagine owning stock in a company where the price appreciates greatly, you sell it, and pay no tax on your profit. That’s what can happen with qualified small business stock (QSBS). Also referred to as Section 1202 stock because that’s the section in the Tax Code that governs it, QSBS can be a significant planning tool for the right company, such as a tech startup.

What is qualified small business stock?

While the tax break for QSBS is very generous, the definition of it is very restrictive. There are many conditions; the key ones are:

  • The issuer must be a C corporation in the U.S. (it can’t be an S corporation).
  • The corporation’s assets must be $50 million or less at all times after August 9, 1993 (or the period of the company’s existence) before and after the issuance of the stock.
  • The corporation must be an active business (not a holding company) at all times that the stock is held.
  • The corporation must be in a business other than one involving personal services; banking, insurance, financing, leasing, or investing; farming; mining; or operating a hotel, motel, or restaurant. Essentially, then, permissible businesses include manufacturing, retailing, technology, and wholesaling.
  • Both the corporation and the shareholder must consent to provide certain documentation for the stock.
  • The stock must be acquired in exchange for money or property or as pay for services provided to the corporation. Someone who acquires QSBS from another person usually cannot take advantage of the tax break for gain on the sale of the stock.

Tax treatment for shareholders

The tax treatment for a shareholder depends on how long the QSBS is held and when it was acquired:

  • Stock acquired after September 27, 2010: If it’s held for more than five years, there is no tax on the gain. It is free from income tax, alternative minimum tax, and the 3.8% net investment income tax. If it’s held for more than one year but not more than five years, the gain is treated like any other capital gain taxed at up to 20%. If the stock is held for one year or less, the gain is short-term capital gain that is effectively taxed as ordinary income.
  • Stock acquired between February 18, 2009, and September 27, 2010: If it’s held for more than five years (which would be shares held now), then 75% of the gain is excludable from gross income. Also, 7% of the gain is subject to the alternative minimum tax.
  • Stock acquired before February 18, 2009: The exclusion of gain is limited to 50%, and 7% of the gain is subject to the alternative minimum tax.

In any event, the excludable gain is limited to the greater of $10 million or 10 times the adjusted basis of the investment.

If the holding period for the optimum exclusion is not met, gain can be deferred by reinvesting proceeds in stock of another qualified small business within 60 days of the sale. To use this deferral option, the stock merely had to be owned for more than six months.

Strategies for using QSBS

Because of the potential for reaping big profits at no tax cost, companies that can qualify as a “small business” for this purpose should consider using their stock strategically:

Attracting investors. Companies starting up and those looking to expand may use QSBS as a way to raise capital. Because the exclusion only applies to individuals, and not to corporations, investors who could benefit from the tax break for QSBS are individuals and individual partners in partnerships.

The stock can be acquired by a partnership so that a partner (who is an individual and not a corporation) can use the exclusion as long as he or she was a partner when the stock was purchased and at all times thereafter. The exclusion is limited to the partner’s percentage interest in the partnership at the time the stock was acquired.

Rewarding employees. Because it is permissible to issue QSBS in exchange for services, this can be a useful tool for startups and other companies short of cash to compensate employees. It also works as an inducement to retain employees; their stake in the company is incentive to work hard and help it succeed.

When issuing QSBS that does not have any restrictions, there are still payroll tax costs to the company. The value of the stock, which is equal to the compensation that would have been paid instead for the services performed, is taxable compensation to employee. It is subject to income tax withholding, Social Security and Medicare (FICA) taxes, and FUTA (federal unemployment) tax. The withholding must be paid in cash, which usually is taken from other cash wages (it can be paid separately by the employee or by the company as additional compensation subject to additional payroll taxes). Income tax withholding for the stock (an in-kind payment) can be done in two ways:

  • Add the value of the stock to regular salary or wages and figure withholding in the usual way on the total amount.
  • Withhold a flat 25% of the value of the stock. If the value exceeds $1 million, the withholding percentage is 39.6%.


If you have a C corporation or are thinking of forming one and you are in an eligible industry described earlier, consider using qualified small business stock to raise capital or compensate key employees. Talk to a tax advisor to make sure that all conditions for being a qualified small business are met before you proceed.

About the author