Tax Treatment of QSBS Gains in Massachusetts

Investors holding Qualified Small Business Stock (QSBS) can benefit from federal tax exclusions on capital gains, but state-level tax implications vary. Massachusetts has a distinct approach to QSBS gains that differs from federal rules. The state offers its own tax benefits that can serve as a valuable alternative for investors.

Federal QSBS Framework

Section 1202 of the federal tax code provides an incentive for investing in small businesses through Qualified Small Business Stock. This provision allows non-corporate taxpayers to exclude a portion of the capital gains from the sale of eligible stock. For stock to be considered QSBS, it must be acquired by the taxpayer from a domestic C corporation at its original issuance for money, property, or services. A financial constraint is that the corporation’s gross assets must not have exceeded $50 million before or immediately after the stock was issued.

Another component is the active business requirement. Throughout the taxpayer’s holding period, at least 80% of the corporation’s assets must be used in a qualified trade or business. Certain industries are excluded, such as banking, insurance, and some personal service businesses like health or law. The taxpayer must hold the stock for more than five years to qualify for the gain exclusion. The amount of excludable gain is generally the greater of $10 million or ten times the taxpayer’s adjusted basis in the stock.

Massachusetts Treatment of QSBS Gains

Massachusetts has a distinct approach to taxing gains from Qualified Small Business Stock that differs from the federal government’s treatment. For tax years beginning on or after January 1, 2022, Massachusetts conforms to the 2022 version of the IRC. This allows for a 100% exclusion for eligible QSBS gains on stock acquired after September 27, 2010. Before this change, Massachusetts law was tied to the 2005 version of the IRC, which limited the QSBS gain exclusion to 50%.

For gains not qualifying for the 100% exclusion, Massachusetts law provides a secondary benefit. Certain small business investment gains may be taxed at a reduced rate of 3% instead of the standard long-term capital gains rate. To qualify, the investment must be held for at least three years and meet several other requirements:

• The corporation must be domiciled in Massachusetts.
• The corporation must have been incorporated on or after January 1, 2011.
• The corporation must have had less than $50 million in assets at the time of investment.
• The investment must have been made within five years of the corporation’s incorporation date.

The standard long-term capital gains tax rate in Massachusetts is 5%. Short-term gains on assets held for one year or less are taxed at 8.5% for tax years beginning in 2023.