The QSBS Exemption And California’s State Taxes

The Qualified Small Business Stock (QSBS) exemption offers enticing federal tax benefits for investors looking to minimize capital gains tax and entrepreneurs looking for investment. In most states, these tax benefits apply to the state-level taxes too. However, California’s tax landscape presents unique challenges and considerations when it comes to the QSBS exemption. 

The QSBS Exemption 

Very briefly – Qualified Small Business Stock (QSBS) is stock in a domestic “C” corporation that meets specific requirements discussed in more detail below.  

If these criteria are met, and the stock is held for more than five years, shareholders may be eligible to exclude a significant portion of their capital gains from federal income tax when they sell the QSBS. This exclusion can incentivize investment in small businesses.  

Let’s Dig Into The Criteria In More Detail 

There are five key criteria investors must meet to qualify for the QSBS Exemption:  

1. Stock acquisition requirements.  
2. Business asset limits.  
3. Type of business exclusions.  
4. Active business requirement.  
5. Holding period requirements. 

Let’s delve into these criteria in more detail.  

 Stock Acquisition Requirements 

There are three key elements to the stock acquisition requirements:  

• Original Issuance: To qualify, the stock generally must have been acquired directly from the company when it was initially issued, not purchased from another shareholder. 

• Payment: The stock must have been acquired in exchange for money, property, or services.  

• Control: If the stock is acquired in exchange for property that is stock in another corporation, there’s an 80% control requirement. Essentially, the corporation issuing the QSBS must have 80% control of the corporation whose stock is being exchanged. 

Business Assets Limit 

To be eligible for the QSBS tax benefits, the investment must be made in a business that does not exceed the asset ceiling:  

• $50 Million Cap: The corporation’s gross assets (total assets without deducting any liabilities) cannot exceed $50 million at any time before the stock is issued or immediately after it is issued. 

• Asset Calculation: Gross assets include cash and the “tax basis” of other property held by the corporation. Note that the fair market value of contributed property, rather than its “tax basis,” might be relevant in certain cases. 

Type of Business Exclusions 

Businesses that offer services in a variety of regulated professions are excluded, alongside businesses that operate in certain specified industries:  

• Ineligible Industries: Certain industries are excluded from QSBS eligibility, including businesses primarily providing services in law, engineering, accounting, health, consulting, financial services, banking, investing, insurance, real estate, hotels, restaurants, farming, and commodities extraction. 

• Skill-Based Businesses: Businesses where the principal asset of the business is the skill or reputation of one or more employees are also generally excluded. 

• Exception: A company may still qualify if it provides products or services that are used in an excluded industry, depending on the specific circumstances. 

The Business Must Be Active 

At least 80% of the corporation’s assets must be used in the active conduct of a qualified trade or business for it to be eligible for QSBS tax benefits. Holding excessive passive assets, such as stock, securities, or real estate not used in the business, can disqualify an investor from claiming QSBS tax benefits. 

Holding Period Requirements 

Investors must hold the stock for more than five years to qualify for the full benefit of the QSBS Exemption. However, there are some strategies that can be employed if stock has been held for a shorter period of time before being sold or otherwise disposed of:  

• Tacking: In certain situations, the holding period of previously owned QSBS may be added to the holding period of other stock that has been acquired. 

• Rollover: If QSBS is sold after being held for more than six months, the gain may be rolled over into other QSBS within 60 days, potentially deferring tax. 

How The QSBS Works In California 

Although the federal tax code provides the overarching framework for QSBS tax benefits, individual states have their own rules and regulations regarding QSBS benefits. In California, QSBS tax benefits are not currently available for state tax purposes, but this has not always been the case and could change in the future.  

Regardless of the current California state tax issue, the QSBS exemption and other QSBS tax benefits remain tools for California businesses and investors. By implementing strategies to meet the qualifying criteria and working with a qualified tax attorney, you may be able to access the significant federal and state benefits available for QSBS. 

CGL has recently expanded its tax expertise. If you need a tax attorney, reach out. Our team is available to help. 

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