How to Report QSBS on Your Tax Return

An investment in a Qualified Small Business Stock (QSBS) can provide a tax advantage through the gain exclusion available under Section 1202 of the Internal Revenue Code. For stock acquired after September 27, 2010, this allows for excluding 100% of the capital gain from federal income tax. This benefit is subject to a cap, which is the greater of $10 million or 10 times the adjusted basis of the stock. Realizing this benefit depends on accurate tax reporting, and navigating the specific forms and procedures is necessary to secure the exclusion.

Confirming QSBS Eligibility and Gathering Documentation

Before reporting, a taxpayer must confirm the investment meets the definition of QSBS. The stock must be issued by a domestic C-corporation that is not in an ineligible field, such as finance, farming, or hospitality. The corporation’s gross assets must not have exceeded $50 million before or immediately after the stock was issued. It must also satisfy an active business requirement, where at least 80% of its assets are used in a qualified trade or business.

To claim the full gain exclusion, the taxpayer must have held the stock for more than five years. This holding period is a requirement for eligibility. If the stock is sold before the five-year mark, the gain is generally taxable, although other options like a Section 1045 rollover may be available. Verifying these dates is part of the documentation process.

A QSBS attestation letter from the issuing corporation is a key piece of evidence, serving as the company’s confirmation that the stock meets the statutory requirements. The letter should explicitly state that the corporation was a qualified small business at the time of issuance, confirm its status as a domestic C-corporation, and affirm that its gross assets did not exceed the $50 million threshold. Without this letter, a taxpayer’s claim for the exclusion during an IRS audit would be weakened.

The taxpayer will also receive a Form 1099-B from their brokerage firm, which details the gross proceeds, cost basis, and sale dates. The broker will not identify the stock as QSBS; the responsibility for claiming the exclusion rests with the taxpayer. If the QSBS was acquired through a pass-through entity like a partnership, the information will be on a Schedule K-1.

Step-by-Step Reporting on Federal Tax Forms

The reporting process begins with Form 8949, Sales and Other Dispositions of Capital Assets, which reconciles amounts from Form 1099-B. For a QSBS exclusion, the sale is reported in Part II for long-term transactions. The taxpayer will check box (F) at the top of Part II because the basis reported on Form 1099-B is incorrect for this purpose.

For example, a taxpayer sells QSBS for $1 million that was acquired for $100,000. On Form 8949, the taxpayer enters the proceeds in column (d) and the cost basis in column (e) as reported by the broker. In column (f), the taxpayer enters code ‘Q’ to indicate the exclusion. In column (g), the excluded gain of $900,000 is entered as a negative number (-$900,000). This adjustment results in a gain of $0 reported in column (h) for this transaction.

The totals from Form 8949 are carried over to Schedule D, Capital Gains and Losses. This ensures the adjusted gain from Form 8949 flows to the correct line and the excluded QSBS gain is not included in the taxpayer’s taxable income.

Making a Section 1045 Rollover Election

Investors who sell QSBS without meeting the five-year holding period can use a Section 1045 rollover to defer capital gains. This provision allows a taxpayer to roll over the proceeds from a QSBS sale into a new QSBS investment. The replacement QSBS must be purchased within 60 days of the sale of the original stock to defer the tax liability.

The election to defer gain is made on the tax return for the year of the sale using Form 8949. The taxpayer reports the sale of the original QSBS, using code ‘R’ in column (f) to signify a rollover. The amount of the deferred gain is then entered as a negative number in column (g).

A statement must be attached to the tax return declaring the Section 1045 election. This statement must include details of the original QSBS sale, such as the sale date and realized gain. It must also provide information on the replacement QSBS, including the purchase date, the new company’s name, and the cost, affirming the purchase was made within the 60-day window.

State Tax Reporting Considerations

State tax laws do not always align with federal regulations. State tax conformity determines whether a state adopts the federal tax code, including provisions like the QSBS exclusion. Many states automatically conform, meaning they also allow for the full exclusion of QSBS gains. This simplifies tax filing, as the federal adjusted gross income can be used as the starting point for the state return.

Some states do not conform to the federal rules. In these jurisdictions, a taxpayer must add the federally excluded QSBS gain back to their state taxable income. This means the gain, while free from federal tax, remains fully taxable at the state level, which can result in a large tax liability.

A third category includes states that partially conform or have their own unique rules. For instance, a state might offer a smaller percentage exclusion or impose different eligibility requirements, such as requiring the company to have a significant portion of its employees within that state. Because of this variation, taxpayers must verify the specific QSBS tax treatment in their state of residence, often by consulting the state’s tax agency website or a tax professional.