What is Qualified Small Business Stock (QSBS)?

As business and business needs continue to emerge and change in this ever-evolving economic environment, tax practitioners must carefully assess how these changes impact or create planning opportunities. 

Because of the considerable tax benefits, one such opportunity, Qualified Small Business Stock (QSBS), has become an integral part of planning for small and growing businesses and business owners. For practitioners advising these clients, one of the new questions of the day is if and how QSBS fits into in the new and growing FinTech industry.

What is Qualified Small Business Stock

QSBS is stock of a domestic C corporation whose gross assets at the actual issuance of the stock do not exceed $50 million. While QSBS has existed since August 11, 1993, more recent tax law passed in September 2010 has significantly enhanced the benefits. Specifically, for QSBS acquired after September 28, 2010 and held for five years, a taxpayer is able to exclude up to $10 million of the capital gains from taxation.

Holding the stock for five plus years as well as making sure the corporation has gross assets under $50 million dollars at the time of issuance is a relatively straightforward and quantifiable measurement.  However, where determining the qualification for QSBS can be more subjective is the additional requirement that the company must be a qualified trade or business.

Qualified Trade or Business

The Internal Revenue Code defines qualified trade or business for purposes of QSBS as any trade or business other than:

  • Any trade or business involving the performance of services (and the Internal Revenue Code lists a number of specific service businesses) or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more employee
  • Any banking, insurance, finance, leasing, investing or similar business
  • Any farming business
  • Any business involving the production or extraction of products where depletion is allowable

As noted above, companies that derive revenue from services or skilled labor will generally not qualify as QSBS. Even though some service industries will rarely ever change, others are constantly changing, even more so with the Information Revolution that is currently still taking place. In particular, one of the biggest industries to have recently appeared is Fintech, an industry which cannot simply be labeled either a service or technology company.

Rise of FinTech

FinTech is the term used for an economic industry composed of companies that use technology to provide or help financial services. It encompasses a wide range of companies from Credit Karma to Square. It has been coined as one of the most promising new industries by sites such as Forbes and The Economist and many in the start-up community have sought and are still seeking market share in this growing industry.

As an industry that is trying to disrupt incumbent financial systems and challenge traditional corporations that are less reliant on software, these small startups are one of the perfect places to begin investing in a world that has become more dependent on technology and less dependent on human skills. For those making early investments in start-ups in the FinTech industry, the ability to exclude the first $10 million of capital gain from federal taxation is certainly a welcome and added bonus to any return.

Does FinTech Qualify?

As defined, FinTech companies dabble in two sectors that were once seen to be wholly different. It is therefore not surprising that certain companies classified under FinTech lean more towards the Tech while others more towards the Fin. Certainly, those companies that lean more towards the Finance of the FinTech will find it more challenging to claim a QSBS position as any financing business is specifically stated as a disqualified business under the tax law. However, what about those companies that lean more towards Technology? Is it enough to overshadow their involvement in financing and qualify them for QSBS?

Diving Deep

By way of example, FinTech companies such as Square are immediately better known for their technological products such as the Square Reader. Yet their involvement with financials, such as Square Register, software that combines payment processing with point-of-sale functionality like itemization and inventory management, raises the question as to whether such activity defines them as a finance company for purposes of QSBS. 

Breaking the rules down: the two biggest points of emphasis made for businesses excluded is 1) the company’s dependence on the skill/reputation of one or more of its employees, and 2) whether the company performs legitimate services in the disqualified industry. A company such as Square is not so heavily dependent on its employees’ skills to bring in revenue but rather in the functionality of their technological products, bypassing the first rule that would have effectively banned it from qualifying.

A part of Square’s revenue, however, also comes from a percentage of each transaction when a card is swiped with its Square Reader. The question becomes, is Square effectively performing a service to its clients in the finance industry? At least some practitioners believe the answer to be no.

In one Tax Court case, IRS challenged an entity structured as a training facility for an insurance business, and denied QSBS status as a disqualified service business, relying on the reputation or skill of one or more employees. The court disagreed with the IRS argument and indicated that the principal asset of the company was the training and organization structure. As such, the reasoning in this case provides an understanding that a company with primary assets in something other than the skill or reputation of individuals such as technology, but functioning as a facilitator in a disqualified industry, does not necessarily disqualify that company from meeting QSBS requirements. 

Square’s main line of business is providing software and hardware products that help streamline financing for the client, but its actual business does not perform the financial services. As a result, Square shares could effectively qualify for QSBS treatment for those investors who acquired shares when the company’s gross assets were still under $50 million.

Similar yet Unique

Although there are similarities, the question of whether a corporation in the FinTech industry can qualify for QSBS treatment must be determined on a case-by-case basis and with careful consideration and analysis to effectively come to a conclusion. While taxpayers can benefit greatly, it is advisable to work with a professional advisor familiar with the intricacies of QSBS to address all the requirements and avoid traps.