Legal Definitions - qualified small business stock

Qualified Small Business Stock refers to shares in certain small businesses that, when held for a specific period, can qualify for a significant federal income tax exclusion on capital gains when sold.

This provision is designed to encourage investment in small, growing companies by offering a substantial tax incentive to investors. For stock purchased after September 27, 2010, investors may be able to exclude up to 100% of the capital gains from their federal taxable income, up to certain limits.

To qualify, the stock and the issuing company must meet several strict criteria:

• C Corporation: The stock must be issued by a domestic C corporation.
• Original Issuance: The stock must generally be acquired directly from the company (or through an underwriter) at its original issuance. This means buying shares on the open market from another investor typically does not qualify.
• Asset Cap: At the time the stock is issued, the company's total gross assets must not exceed $50 million. If the company's assets grow beyond $50 million *after* the stock is purchased, that specific stock can still qualify, but any new stock issued once the company exceeds the $50 million cap will not.
• Active Business Requirement: For substantially all of the investor's holding period, the company must be an active business in a qualifying industry. Certain types of businesses, such as those primarily involved in professional services (e.g., law, health, accounting), banking, finance, real estate, or hospitality, generally do not qualify.
• Holding Period: The stock must be held for more than five years from the date of purchase.

Examples:

• Early-Stage Tech Investment: Sarah invests $75,000 in "Quantum Leap Innovations," a newly formed C corporation developing AI software, by purchasing shares directly from the company during its initial funding round. At the time of her investment, Quantum Leap Innovations has total assets of $8 million. Sarah holds her shares for six years. When she sells them, Quantum Leap Innovations has grown significantly and her investment is worth $1 million. Because her stock met the criteria of being from a C corporation, purchased at original issuance when assets were under $50 million, and held for over five years, Sarah may be able to exclude a substantial portion of her $925,000 capital gain from federal income tax.

• Founder's Initial Equity: Michael starts "EcoBuild Solutions," a C corporation focused on sustainable construction materials. As part of the company's formation, he receives shares in exchange for his initial capital and intellectual property when the company's total assets are less than $1 million. Over ten years, EcoBuild Solutions thrives and grows into a company with assets exceeding $150 million. If Michael decides to sell his original shares, they would still qualify as Qualified Small Business Stock because the company met the under-$50-million asset threshold at the time his shares were originally issued, and he held them for more than five years. This demonstrates that the asset cap applies at the time of purchase, not continuously throughout the holding period.

• Angel Investment in a Manufacturing Startup: An angel investor, Mr. Chen, purchases $200,000 worth of stock directly from "Precision Robotics Inc.," a C corporation manufacturing specialized industrial robots. At the time of his investment, Precision Robotics Inc. has assets totaling $25 million. Mr. Chen holds his shares for seven years before selling them. His investment qualifies because he acquired the stock directly from a C corporation whose assets were below the $50 million threshold at the time of purchase, and he satisfied the five-year holding period requirement. This allows him to potentially benefit from the significant tax exclusion on his capital gains.