Qualified Small Business Stock (QSBS) offers a powerful tax incentive for those investing in early-stage US startups. For US citizens and residents who meet specific requirements, QSBS can provide a significant tax exemption on gains from the sale of the stock.

What Qualifies as QSBS?

To be considered Qualified Small Business Stock under Section 1202 of the Internal Revenue Code, the investment must meet several conditions:

The stock must be in a C corporation. The corporation must be a domestic US company. The corporation’s gross assets must not have exceeded $50 million at the time the stock was issued. The stock must be acquired at original issuance, not on the secondary market. The business must actively conduct a qualified trade or business.

Certain industries, such as financial services, hospitality, and professional services, are excluded.

What Are the Tax Benefits?

If the stock qualifies as QSBS, and the investor holds it for more than five years, they may be eligible to exclude up to 100% of the capital gains on sale from federal income tax, subject to a cap. The gain eligible for exclusion is limited to the greater of $10 million or ten times the adjusted basis in the stock.

This can result in a complete federal tax exemption on a substantial portion of the gain. However, the actual exclusion percentage depends on when the QSBS was acquired:

100 percent exclusion: for stock acquired after September 27, 2010. 75 percent or 50 percent exclusion: for stock acquired earlier, subject to Alternative Minimum Tax (AMT).

QSBS for US Expats and Cross-Border Considerations

US citizens living abroad can still benefit from QSBS, as long as they meet the criteria. However, cross-border planning is essential:

Foreign tax treatment:

The country of residence may not recognize the QSBS exclusion. For example, if a US citizen resides in the UK, the UK may tax the entire gain on disposal of QSBS. Double taxation risk: The QSBS exclusion applies only for US tax purposes. If the foreign country taxes the gain, there may be limited or no ability to use foreign tax credits to offset US tax (since no US tax is due).

Treaty protection:

Most tax treaties do not protect QSBS treatment. The gain may be taxed under local law without relief.

Proper tax planning and dual-reporting strategies are crucial for expats with QSBS.

Example: Startup Success

Jane, a US citizen, invests $200,000 in a qualifying California-based startup in 2012. Ten years later, she sells the stock for $5 million. Because she held the stock for more than five years and acquired it after September 27, 2010, she qualifies for a 100 percent exclusion under Section 1202. Jane pays no US federal income tax on $4.8 million in capital gains.

If Jane is living in the UK when she sells the shares, the UK may tax the entire $4.8 million gain unless she qualifies for relief under UK domestic law. She cannot claim a US foreign tax credit, because she owes no US tax on the gain.

Final Thoughts

QSBS is one of the most generous tax incentives in the US tax code, particularly for startup founders, early employees, and investors. But the rules are nuanced, and the benefits can be lost without careful planning. This is especially true for Americans living abroad.

The information in this blog post is for general informational purposes only and does not constitute professional tax advice. We strongly recommend consulting a qualified tax professional before making any decisions. US Expat Tax Advisor is not liable for any actions taken based on this content.

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