Qualified Small Business Stock (QSBS) refers to a special class of stock defined under Section 1202 of the Internal Revenue Code. Its primary benefit is a significant federal capital gains tax exclusion for investors when they sell the stock. For stock acquired after September 27, 2010, the exclusion is typically 100% of the gain, up to a limit of $10 million or 10 times the adjusted basis of the stock, whichever is greater. This tax incentive was designed to encourage investment in innovative, growing U.S. small businesses.

Core Requirements for QSBS Qualification

For stock to qualify as QSBS, several conditions must be met by both the corporation and the shareholder.

1. Requirements for the Corporation:

• Entity Type: The issuing company must be a domestic C-corporation. Stock from S-corporations or LLCs does not qualify, unless the LLC is taxed as a C-corporation.
• Gross Assets Test: At all times before and immediately after the stock is issued, the corporation’s gross assets must not exceed $50 million. Assets are generally valued at their adjusted basis (e.g., cash contributed plus the original cost of property). This test is critical and is performed at the moment of each stock issuance.
• Active Business Requirement: During substantially all of the investor’s holding period, at least 80% of the corporation’s assets (by value) must be used in the active conduct of a “qualified trade or business.”
• Qualified Trade or Business: Most types of businesses qualify, including technology, manufacturing, wholesale, and retail. However, the law specifically excludes certain service-based businesses, such as:
  • Health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any business where the principal asset is the reputation or skill of one or more of its employees.
  • Banking, insurance, financing, leasing, or investing.
  • Farming.
  • Businesses involving the operation of a hotel, motel, or restaurant.

2. Requirements for the Shareholder:

• Original Issuance: The shareholder must have acquired the stock at its original issuance from the company (not on a secondary market like a stock exchange). This can be in exchange for cash, property (other than stock), or as compensation for services rendered to the corporation.
• Holding Period: The shareholder must hold the stock for more than five years to be eligible for the tax exclusion.
• Type of Shareholder: Applicable for individuals, single-member LLCs, multi-member LLCs (pass-through entities for their members), S-corporations (pass-through entities for their shareholders), trusts.  C-corporations and retirement accounts are NOT eligible.

Likelihood of Smaller Bio- and Med-tech Companies Qualifying

There is a strong possibility that stock issued by smaller bio- and med-tech companies could be QSBS. Here is an analysis:

Favorable Factors:

• Industry: ” The R&D, development, and manufacturing inherent in biotech and med-tech are classic examples of a “qualified trade or business.” They are not typically considered a disqualified “health service” which usually refers to the direct practice of medicine (like a doctor’s office).
• Company Stage: Companies in early fundraising rounds (Seed, Series A, etc.), are almost certainly below the $50 million gross assets threshold. Founders, early employees, and angel/VC investors who received stock during these early stages are the most likely to hold qualifying shares.

Critical Questions to Verify for Each Company:

Despite the positive indicators, qualification is not automatic. For any given investor to benefit from QSBS, the following must be confirmed:

1. Is the company a C-corporation? This is the first and most critical hurdle. If any of your clients are structured as LLCs (and not taxed as a C-corp), their stock/units will not qualify. This is the most important piece of information to ascertain.
2. What were the gross assets at the time of investment? For an investor’s stock to qualify, the company must have been under the $50 million asset cap immediately after that specific investment. The company’s CFO or legal counsel should be able to provide an attestation letter confirming this for various funding rounds.
3. How long has the investor held the stock? The five-year holding period is absolute. This is a shareholder-specific requirement.

Summary for Companies Considering QSBS qualification:

For fundraising and building investor presence, highlighting the potential for QSBS treatment can be a powerful tool. Companies can obtain a QSBS attestation letter from legal counsel, which they can then provide to prospective investors as part of the due diligence package.

New Rules Effective post-July 4, 2025

New tax rules for investments or stock issuance after July 4, 2025:

Higher tax-reduction limits:

 $10 million gain cap moves up to $15 million.

A laddered tax reduction based on holding period:

50% exclusion for stock held for at least three years.

75% exclusion for stock held for at least four years.

100% exclusion for stock held for five years or more.

Higher company asset limits:

Increases the gross asset limitation from $50 million to $75 million

Investor and Company Steps in Claiming QSBS Credit

Think of it as a two-part process: The investor makes the claim, and the company provides the essential evidence to back it up.

The Investor’s Responsibility: Claiming the Exclusion

For an investor, the entire process happens when you file your taxes for the year in which you sold the stock. You must report the sale and claim the exclusion.

Report the Sale on Form 8949: You report every stock sale on IRS Form 8949, “Sales and Other Dispositions of Capital Assets.” For a QSBS sale, you will list the full details of the transaction:

Description of the stock (e.g., 1,000 shares of XYZ Corp.)

Date acquired and date sold

Total sale proceeds

Your cost basis

Enter the Exclusion Code and Amount: This is the key step. On Form 8949, in column (f) for “Code(s),” you will enter Code Q. In column (g) for “Adjustment,” you enter the amount of your excluded gain as a negative number.

Calculate the Exclusion: The amount you enter in column (g) depends on your holding period, especially for stock acquired after the “One Big Beautiful Bill Act” was enacted on July 4, 2025.

Transfer to Schedule D: The totals from Form 8949 are then carried over to Schedule D, “Capital Gains and Losses,” which calculates your final tax liability.

The Company’s Role: Substantiation and Support

While the issuing company does not file a special form with the IRS stating its stock is QSBS, its role is arguably the most important part of the entire process. The burden of proof is on the investor if the IRS ever audits the claim. Without the company’s cooperation, proving eligibility is nearly impossible.

The issuing company must:

Meet All QSBS Requirements: The company must have met all the statutory requirements at the time the stock was issued to you. This includes being a domestic C-corporation, having gross assets below the threshold (now $75 million), and satisfying the “active business” requirement.

Provide Documentation to the Investor: Upon request, the company should provide the investor with the necessary information to substantiate a QSBS claim. While there is no official IRS form for this, it is often done through a QSBS Attestation Letter. This is a formal statement from the company confirming that, to the best of its knowledge, it met the QSBS criteria on the date the stock was issued.

Maintain Adequate Records: The company needs to keep thorough corporate and financial records that can support its attestation. This includes:

Financial statements or balance sheets to prove the gross asset test was met.

Articles of Incorporation to prove it is a domestic C-corporation.

Records demonstrating that at least 80% of its assets were used in a qualified trade or business.

An investor is advised to proactively request a QSBS attestation letter and confirmation of the company’s status when they make their investment and retain all purchase agreements and corporate documents. Relying on memory years later when you sell the stock is a significant risk.

Prepared by Putnam Insights LLC
(contact Ray Jordan, ray@putnaminsights.com)