The QSBS $10 Million Limit and How to Exceed It

An investment in a qualifying startup can yield significant returns, and a provision in the tax code can make those returns more lucrative. Section 1202 of the Internal Revenue Code offers a tax incentive related to Qualified Small Business Stock (QSBS), allowing investors to exclude a substantial amount of their capital gains from federal income tax. For stock acquired after September 27, 2010, this could mean excluding 100% of the taxable gain.

This tax benefit is not unlimited, as the law places a cap on how much gain an individual can exclude per company. Understanding this cap is the first step for any investor looking to maximize their tax savings. This article explores the specifics of the gain exclusion limit and the planning strategies available to potentially increase it.

Core Requirements for QSBS Eligibility

For stock to be designated as QSBS, it must meet a set of criteria at its issuance and throughout the investor’s holding period. The foundational requirement is that the issuing company must be a domestic C-corporation. Entities structured as S-corporations or LLCs do not issue QSBS, although they can sometimes be converted to C-corporations to enable future stock to qualify.

An investor must have acquired the stock at its original issuance, meaning they purchased the shares directly from the company. This can be in exchange for money, property, or as compensation for services. Acquiring stock on a secondary market, such as from another shareholder, would disqualify it from QSBS treatment for the new owner.

A financial test the corporation must pass is the gross assets test. At all times before and immediately after the stock is issued, the corporation’s aggregate gross assets cannot exceed $50 million. This calculation includes cash, the adjusted basis of property held by the corporation, and the amount received in the issuance itself.

The corporation must also satisfy an active business requirement, meaning at least 80% of its assets must be used in the active conduct of a qualified trade or business. Certain business types are excluded, primarily in fields like health, law, finance, and hospitality. To claim the gain exclusion, the shareholder must hold the stock for more than five years, with the holding period beginning on the date the stock is acquired.

Calculating the Gain Exclusion Limit

The amount of capital gain an investor can exclude from federal income tax under Section 1202 is subject to a specific limitation. The law dictates that the excludable gain for a single taxpayer, per issuer, is capped at the greater of two distinct amounts.

The first part of the calculation is a lifetime cap of $10 million per issuer. A taxpayer can exclude up to $10 million in gains from selling stock of a single qualified small business over their lifetime. Any gains realized from that company’s stock beyond this cumulative threshold would be subject to standard capital gains taxation.

The second part of the calculation is the 10x basis cap. This alternative limit allows a taxpayer to exclude gains equal to 10 times their aggregate adjusted basis in the QSBS of the issuer that is sold during the tax year. The “aggregate adjusted basis” is the total amount the investor paid for the stock, including cash or the value of property or services.

To illustrate, consider an investor who acquired QSBS by paying $2 million. Upon selling the stock years later for a $12 million gain, their exclusion limit would be the greater of $10 million or 10 times their basis ($2 million x 10 = $20 million). In this scenario, the $20 million limit is greater, so the entire $12 million gain would be excludable.

Strategies for Increasing the Exclusion

While the per-taxpayer exclusion limit is fixed, strategic planning can legally multiply the benefit. This approach centers on the fact that the QSBS gain exclusion is applied on a per-taxpayer basis. By transferring stock to other individuals or entities, it is possible to create multiple, separate taxpayers, each eligible for their own exclusion limit.

One common strategy is gifting QSBS to other individuals, such as family members. When QSBS is gifted, the recipient steps into the donor’s shoes, inheriting the original purchase date and cost basis, and the five-year holding period continues uninterrupted. Upon a subsequent sale, each recipient can claim their own separate exclusion, capped at the greater of $10 million or their 10x basis in the gifted shares.

A more complex strategy involves transferring QSBS into specific types of trusts. By establishing one or more irrevocable non-grantor trusts, an individual can create new, distinct legal taxpayers. Each of these trusts can then hold QSBS and, upon its sale, claim its own independent gain exclusion.

These strategies are most effective when implemented early, ideally when the company’s valuation is low. Gifting stock before it appreciates significantly can help minimize potential gift tax consequences, which are based on the fair market value at the time of the transfer. Proper planning requires considering annual gift tax exclusions and the lifetime gift and estate tax exemption.

Reporting the QSBS Exclusion

Once an investor has sold their stock and calculated their allowable exclusion, the final step is to report the transaction to the IRS. The primary forms involved are IRS Form 8949, Sales and Other Dispositions of Capital Assets, and Schedule D, Capital Gains and Losses.

The transaction must be detailed correctly on Form 8949. The taxpayer reports the full details of the sale, including the description of the property, dates of acquisition and sale, and the total sales price and cost basis. In column (f) of the form, the taxpayer should enter the code “Q” to signify that the transaction involves QSBS.

The amount of the excluded gain is reported in column (g) as a negative number in parentheses. This adjustment subtracts the excludable portion from the total gain, resulting in the correct amount of taxable gain flowing from Form 8949 to Schedule D. For example, if a taxpayer has a $12 million gain and is excluding $10 million, they would enter ($10,000,000) in column (g).

Taxpayers should be prepared to substantiate their claim for the QSBS exclusion if questioned by the IRS. This documentation should include records proving the stock met all requirements, such as stock purchase agreements and financial statements demonstrating the company met the $50 million gross assets test.