QSBS: What you need to know as an employee receiving stock

Qualified Small Business Stock (QSBS) can offer a big tax break to employees who get stock as part of their pay. If you work at a startup, knowing about QSBS could help you reduce your tax bill when you eventually sell your stock.

In this article, we’ll explain what QSBS is, how you can get it as an employee, and how to take advantage of the tax benefits.

What is QSBS?

QSBS is a tax incentive that applies to stock issued by early-stage companies. It can potentially give you a 100% exemption on federal capital gains taxes, up to $10 million or 10 times your original investment amount, whichever is greater.

But to fully benefit from QSBS tax relief, you’ll need to have set your company up as a C corporation and held the stock for at least five years before it’s sold.

Only C corporations can issue QSBS, but a company can convert from another structure (such as an LLC or an S corporation) to a C corporation and issue QSBS (as long as the other criteria are met).

Also, if you were issued stock before conversion to a C corporation, you could still benefit from QSBS on that. The gains on that stock before the conversion won’t qualify for QSBS. But gains on the stock after the conversion can qualify for QSBS (provided the company meets the other requirements).

You can find the QSBS rules in Section 1202 of the Internal Revenue Code.

Can employees get QSBS as part of their compensation?

Yes, employees can receive QSBS as part of their compensation (for example, if your employer offers you stock options).

Why is it beneficial? Well, the tax savings with QSBS can be huge as long as the qualification criteria is met (see ‘How do employees qualify for QSBS?’ below). These savings can be especially big for employees who join early and help the company grow.

How do employees qualify for QSBS?

To qualify for QSBS tax relief, there are a few requirements that you (and your employing company) need to satisfy.

1. The issuing company must be a C corporation: The company issuing you the stock must be a C corporation for you to qualify for QSBS. S corporations and LLCs don’t meet the criteria, and neither do foreign companies. Most startups are set up as Delaware C corporations, so this shouldn’t be an issue.
2. The issuing company’s assets must not exceed $50 million: The company’s total gross assets, which include cash and other assets valued at their original cost (plus any investment being raised at the time), must not exceed $50 million when the stock is issued to you (when you actually receive the stock).
3. The issuing company must be an active business: The company you work for must be an active business for you to qualify for QSBS. This means at least 80% of the company’s assets must be used in day-to-day operations, rather than passive activities like owning property or collecting rent. For most startups focused on growing their core business, this requirement is met, so it’s not usually something you need to worry about.
4. The issuing company must not be in an excluded industry: Service businesses like healthcare, law, and financial services generally can’t qualify for QSBS. A full list of excluded businesses can be found at Internal Revenue Code Section 1202(e)(3).
5. You must hold the stock for five years to benefit from the tax relief personally: Employees must hold the stock for at least five years to benefit from the QSBS exclusion. The clock starts ticking once you actually acquire the shares. If you receive stock options as part of your compensation, the five-year period begins when you exercise the options and are issued the shares (not when the options were granted).
   
6. You must receive the stock directly from the company: Employees must acquire their shares directly from the company, whether through a stock grant, option exercise, or purchase. Stock does not qualify as QSBS if it’s acquired through a secondary market transaction (for example, if you buy it from another investor​).

How can employees maximize QSBS benefits?

Verify your employer’s QSBS status

It’s important to know if your employer qualifies to issue QSBS so you can avoid an unexpected tax bill when selling your stock. You can ask the company for a QSBS attestation letter, which outlines how they meet the Internal Revenue Service (IRS) criteria for QSBS. While it’s not a guarantee, having this documentation gives you more confidence that you’ll get the tax benefits.

Exercise stock options early

If you’re able to, exercising your stock options as soon as you’re eligible can be a smart move because it starts the five-year holding period required to claim QSBS tax benefits. The earlier you exercise, the sooner you can qualify for the QSBS tax benefits. Just be aware that exercising options may trigger an immediate tax liability, so consider the timing carefully based on your financial situation.

Make an 83(b) election

If you receive stock options, filing an 83(b) election with the IRS can be a beneficial strategy. By doing this, you choose to pay taxes on the stock’s value at the time of grant, not when it vests. This also triggers the five-year QSBS holding period sooner.

What is an 83(b) election? An 83(b) election is a letter you send to the IRS letting them know you’d like to be taxed on your share option on the date it was granted to you rather than on the date it actually vests.

This can save you money if you expect the stock’s value to increase significantly, as it locks in a lower tax bill upfront. Filing the 83(b) election also starts the clock on the five-year QSBS holding period sooner, which means you’ll qualify for QSBS tax exclusions when you sell the stock.

As with any tax-related matter, it’s best you speak to your tax advisor to ensure you understand what strategies are available to you.