QSBS For US Founders
For startup founders, the journey from idea to exit involves numerous financial decisions. Section 1202 of the IRC creates a remarkable incentive to reward the risk-takers who pour their time, resources, and vision into creating small businesses that drive American innovation. QSBS represents one of the most significant tax advantages available to founders who build businesses, not merely to flip them quickly but also to create lasting value in specific sectors of the economy. This powerful tool of the US tax code can save founders and early investors millions when they sell their shares.
If you are a founder or an early-stage investor in the U.S., this article will help you understand the potential tax advantages of Qualified Small Business Stock (QSBS) and how to effectively use this provision to maximize your financial returns when selling shares of qualifying startups.
What is QSBS?
QSBS refers to the shares in a qualified small business that, when held for at least five years, can provide significant capital gains tax exclusions under section 1202 of the IRC. This exclusion can be up to 100% on the sale of these shares, capped at the greater of 10M or 10 times your adjusted basis in the stock.
In short, for founders without the QSBS exemption, long-term capital gains are typically taxed at rates of up to 20% federally, in addition to the 3.8% net investment income tax, and any applicable state taxes.
According to Joint Committee on Taxation data, QSBS exclusions save founders and investors an estimated $1.3 billion annually. In Silicon Valley alone, over 65% of venture-backed startups now structure specifically to qualify for benefits. The average tax savings for founders at exit is approximately $2.1 million per qualifying founder.
QSBS Eligibility Criteria for Founders
A qualified small-business stock is an equity share in a qualified small business (QSB). A QSB is an operational C-corp with assets of less than $50 million at the time of the issue of stock. QSBS allows founders and investors to qualify for tax benefits on capital gains of up to $10 million or ten times the investment.
As QSB stocks offer significant benefits to both investors and eligible small businesses, eligibility has been stringent. Several conditions need to be met for a stock/company to be eligible.
- Company Structure: The business should be an active business registered as a C-Corp in the US.
- Holding period: Investors need to hold QSBS-eligible stock for at least 5 years to realize tax benefits. In case of conversion into stock from other security types, the holding period starts from the date of conversion.
- Assets limit: Gross assets of the company should not exceed $50 million immediately after the issuance. In addition, at least 80% of the assets should be used for an eligible business.
- Eligible businesses: While several businesses are eligible under QSB, generally, service-intensive industries such as healthcare, law, finance, hospitality, and consulting do not qualify. Engineering and architecture-based businesses are also not eligible.
- Redemption: No significant redemption of the stock (5% of the total outstanding stocks) in the two years before the QSB status is granted.
With the potential to save millions in taxes, it’s a topic that deserves careful consideration by any founder looking to maximize the value of their hard work and innovation.
QSBS in Action: Examples of QSBS Tax Benefits
Tax benefits, as enshrined in Section 1202 of the IRC, were added in 1993 to promote small businesses. Tax benefits have changed since then and have become more favorable over time. The table summarizes the tax benefits discussed earlier.
| Time-Period | Capital gains exclusion benefits | AMT addback |
|---|---|---|
| August 10, 1993, and February 17, 2009 | 50% | 7% |
| February 17, 2009, to September 27, 2010 | 75% | 7% |
| After September 27, 2010 | 100% | No addback |
Assume a single taxpayer with $850,000 in ordinary annual income. The tax rate on capital gains will be 20%. Now, if this taxpayer purchased an eligible stock on June 16, 2019, and sold it on July 9, 2024, with a profit of $150,000, the tax applicable will be $0 because after September 27, 2010, gains are 100% eligible for exclusion.
If the same stock was purchased on 10th October 2001 and sold on 11th October 2006, the applicable capital gains tax will be:
Capital gains Tax = 20%$150,00050%=$15,000
However, this will be subject to a 7% AMT add-back. The tax-excluded portion is $75,000 (50% of $150,000). The AMT tax rate in 2006 was 28%. So the AMT add-back would be:
AMT addback = 28%$75,0007%=$1,470
In any case, if the stocks are sold before five years and the proceeds are not invested in another eligible QSBS stock within 60 days, zero capital gains tax exclusions will apply. This example demonstrates that benefits under QSBS have increased ever since its introduction in 1993. This helps founders with investments and opens up a new asset class for investors, helping diversify their portfolio.
How Founders Acquire QSBS
The QSBS status carries various benefits for small business founders. However, attaining requires you to meet strict compliance requirements. Follow these key steps to maintain compliance.
- Step 1 – Convert into a C-corporation: Incorporate your business as a C-corporation in a state that offers favorable operational and regulatory conditions. Ensure that your corporate structure and bylaws are clear and unequivocal.
- Step 2 – Meet the asset value threshold: QSBS status cannot be attained if a business’s gross asset value exceeds $50 million. Consider hiring a third-party expert to certify your gross asset value and facilitate compliance.
- Step 3 – Document the stock purchase agreements (SPAs) and shareholder’s agreements: Maintain comprehensive documentation for:
- Stock purchase agreements (SPAs): Include the number of shares issued, par value, purchase price, and any special terms such as vesting schedules.
- Shareholder agreements: Outline voting rights, preemptive rights, and restrictions.
- Step 4 – Board approval: Ensure that your board of directors approves the stock issuance in a properly documented meeting. Once the board approves the issuance, record issuance details such as issuance date, par value, and any restrictions.
How Founders Sell QSBS
QSBS to founders and investors offers favorable tax treatments. It is important to plan out the sale of such stocks to avail full benefits. With several legal and regulatory factors to be taken into account, it is always rewarding to hire an expert tax advisor. The aspects that such an advisor will consider include:
- Holding period: The five-year holding period requirement should be met to realize tax benefits. Calculate the date from the initial issue date to the day of sale, making sure 5 years are completed.
- Tax liabilities: The capital gain liabilities, based on differing tax rates for different periods (50%,75%,100%), need to be analysed.
- Scrutinizing documentation: Review the documents, including stock certificates, for any restrictions or rights on the sale of the stock.
- Legal requirements: Hiring securities law advisors can help you review the sale and accompanying documentation. The board’s approval or corporate resolutions for the sale need to be in order.
- Executing the sale: The execution requires documents such as a stock purchase agreement, board approval for the sale, and the transfer of payment. It is always good to retain copies of the required transactions.
- Tax filing: Report the sale using Form 8949 and Form 1040, Schedule D, when you file your taxes for the year. Make a note of the timings of sales and purchases and check if tax exclusions have been applied. A good advisor will be helpful here.
QSBS Pitfalls Founders Need to Understand
QSBS provides a wide array of tax benefits for business owners and investors. It is, therefore, expected that the government would like to include harsh provisions to prevent its misuse. Limits related to assets ($50 million), holding period (5 years), and eligible industries have already been discussed. Failure to adhere to these requirements can disqualify the stock as QSBS compliant. Additional risks include:
- Tax rate changes: Since the benefits are tied to tax rates, any changes in prevailing rates may affect QSBS benefits.
- Ownership limits: These affect the benefits based on exclusion limits. If the stock has risen more than 10 times the value, further benefits will not be realized.
- State taxes: QSBS is a federal tax benefit, and hence, state taxes still need to be paid in places such as California.
- Mergers and Acquisition: As the business grows, it might be acquired or merged with another business. This increases the risk of non-compliance, such as investors not completing 5 years and the new entity being non-compliant.
Strategies to Maximize QSBS Benefits for Founders
By implementing proper strategies together with appropriate professional guidance, founders can potentially save millions in taxes when exiting their businesses.
- Early Planning: Structure as a C-corporation from day one if QSBS benefits align with your business goals.
- Asset Monitoring: Track your company’s gross assets carefully to stay under the $50 million threshold during stock issuances.
- Multiple Taxpayer Planning: The $10 million cap applies per taxpayer, so married couples filing jointly and utilizing trusts can potentially increase exclusion amounts.
- Staggered Investment: Consider making investments in tranches to maximize the basis multiplication benefit (10x basis).
- Documentation: Maintain meticulous records of stock issuances, including dates, amounts, and consideration paid.
Secure your QSBS Tax benefits with Eqvista
QSBS have been instrumental in providing fledgling businesses with much-needed investment. This enhances job creation in low economic activity communities and promotes innovation. The five-year holding period locks in the investment and reduces volatility. Investors get a chance to cash in on innovative and high-growth companies, coupled with complete capital gains tax write-off.
While beneficial, QSBS can include a spectrum of tax and regulatory compliances. Eqvista’s tax advisory and equity consultation service can help you navigate complex requirements, helping you concentrate on running your business. Get in touch with us for a detailed consultation for QSBS services suited to your business.
