Private companies and early-stage startups require funding, for which they need to raise capital with the help of shareholders and investors. And as a result, Congress created a tax law in the United States that provides several tax incentives to people who invest in these early-stage businesses. The U.S. government in 2015 passed The Protecting Americans from Tax Hikes (PATH) Act, which provides a tax exemption for Qualified Small Business Stock (QSBS). With the help of the QSBS exemption, earnings from the sale of a particular type of stock are completely excluded from federal income tax. This regulation has attracted the attention of many venture capitalists, business owners, and investors to invest in early-stage startups and private companies. This article will further focus on QSBS eligibility rules, QSBS tax exclusion, QSBS tax benefits, types of QSBS, and requirements of QSBS tax benefits.
Qualified Small Business Stock Tax Benefits
The Qualifying Small Business Stock (QSBS) exemption is a tax break available to qualified small business (QSB) shareholders in the United States. These early investors are exempted from paying long-term capital gains taxes to the federal government when they sell their shares. The QSBS exclusion is one strategy to motivate people to take the risk of starting, funding, and working for a startup, as these investments are inherently risky.
What is QSBS?
Shares of a qualified small business (QSB), as described in Section 1202 of the Internal Revenue Code (IRC), are referred to as qualified small business stock (QSBS). A QSB is a domestic C corporation with gross assets – when valued at the original price, do not cost more than $50 million at the time of issuance or immediately after. If a QSBS investor meets specific requirements, they might be eligible for tax incentives. The QSBS tax treatment offers a break on capital gains tax when shareholders sell their shares. The tax break might provide a 100% tax exemption on capital gains.
QSBS can generate significant tax savings for startup and private company shareholders, fulfilling its intention of significantly lowering financial risk and tax obligations. This exemption encourages investors to fund the startups they helped build. Shareholders further fuel the massive growth potential of these businesses and the innovation economy in general as they realize the total value of their stock.
Types of QSBS
QSBS offering is a way to acquire initial or additional funding for qualified startups and existing private firms who seek to grow their operations and expand their business. QSBS is often used as a form of in-kind payment and is typically used to pay employees for their services when cash flow is tight. QSBS is sometimes also used by these businesses to compensate their team members for contributing to the expansion and success of the company.
Why is QSBS important?
Shareholders of a Qualified Small Business Stock (QSBS) might be eligible for up to 100% exemption from federal income tax from the sale of QSBS only if specific requirements are met. This means that a shareholder might be able to avoid paying federal tax on profits up to $10 million or 10 times their tax basis. For instance, if you invested $2 million in a QSBS in 2013, you might sell that stock for up to $22 million five or more years later and pay no federal income tax on that gain, allowing you to save up to $5 million at the current tax rate. Both businesses and people must adhere to specific guidelines to qualify for this tax break.
How can you get QSBS stock?
To hold QSBS stocks, you must own shares of a company that qualifies as a QSB; this excludes owning options or any other securities in the company. Another condition to hold QSBS shares is that you must be an individual, a trust, or another type of pass-through business. Only after the exercise and conversion of options, warrants, or convertible debt into stock will your actual holdings become QSBS-eligible. Any exercise-related expenses, taxes, or fees you could owe as a shareholder at the time of participation are unaffected by your potential QSBS eligibility.
A shareholder must hold eligible shares for at least five years after receiving them to be eligible for the tax advantage. If you decide to sell your qualifying shares before the holding period is over, you can be liable for taxes on the sale of those shares. Shareholders may sell their QSBS-qualified shares once the five-year holding period is over and can qualify for up to 100% exemption on federal taxes from the capital gains made at the sale of the company. You can sell the stocks of private companies through tender offers (buyback events), bilateral secondary transactions, and IPO events, among other methods.
QSBS rules and eligibility for business
For small companies to benefit from federal tax incentives, they must be set up in a particular way. The startup or private company must adhere to the following requirements to qualify for the QSBS tax treatment:
- Companies engaged in manufacturing and creating products, such as new technology or widgets, are eligible for tax benefits. Hospitality, personal services, finance, farming, and mining businesses are not eligible to be QSBs. The larger of $10 million, or 10 times the shareholder’s basis in the shares, is the taxable amount that can be deducted from the capital gain on the sale of QSBS.
- The shares must have been acquired by the investor from a `.S. C corporation in return for goods, services, or cash. Additionally, it must be after 1993. This implies that the shares ought to be the first shares issued by the company.
- The investor must have owned the stock for a minimum of five years for the investor to benefit from the tax exemption.
- The QSBS tax exemption is only accessible if most of the company’s assets are linked to an active business or trade. Essentially, at least 80% of the assets must be used in the QSB’s active conduct.
- QSBS was created to encourage investment in small startups and companies to help in their growth and expansion. Hence, by this rule to qualify as a QSB and reap the benefits of tax exemption, the company’s gross assets should be less than $50 million.
- The stock must have been purchased by the investor at the time of original issuance, not on the secondary market.
- A corporation cannot be an investor. In such a case, the company won’t qualify for QSBS.
How does a 409a valuation affect QSBS?
After having previously qualified for QSBS certification, a corporation may be declared ineligible. This occurs due to the company’s 409A valuation changes and or not being accurate. Shareholders can use this time to use their grants to qualify for the QSBS. Thus, it is highly recommended for a company to get a 409A valuation done. The 409A valuation determines the cost of purchasing a company’s share. It is important to know the worth of your company’s share, without which you won’t be able to offer equity to investors and, thus, lose out on raising capital. So, without a 409A valuation, a company won’t qualify for the QSBS tax exemption.
Understanding the QSBS exclusion benefits is simplified for corporations and shareholders using the Eqvista platform for 409A assessments. Eqvista makes it easy for shareholders to keep track of potentially eligible shares. They can also estimate the minimum amount of time they’ll need to hold onto their shares before selling in order to qualify for the QSBS bonus.
If you have questions about the QSBS exclusion, consulting a tax professional is strongly recommended. As a founder, investor, or employee of a company, you may be able to maximize the value of your equity by taking advantage of this perk.
QSBS tax exemption
The QSBS tax exemption offers a break on capital gains tax when shareholders sell their shares. The tax break might provide a 100% tax exemption on capital gains.
How does QSBS tax treatment work?
The limit for a shareholder to avoid paying federal tax on profits is up to $10 million or 10 times their tax basis. Any surplus earnings from the sale over that amount will be subject to ordinary capital gains rates of taxation. In addition to the cap, the timing of the acquisition of the QSBS shares can affect the tax benefit.
Requirements for QSBS tax benefits
Specific requirements need to be met to qualify for QSBS tax benefits, which depend on the date of purchase and the stock’s holding period. The requirements are as follows:
- 100% exemption of capital gains for QSBS bought after September 27, 2010. Capital gains are excluded at 100%, including exemptions from the AMT (alternative minimum tax) and NII (net investment income) tax.
- To qualify for the tax benefits, the business should be an American C corporation.
- The securities issued by the QSB should be post-10th August 1993.
- The taxpayer must directly receive the stock from the company in exchange for cash, another type of property (not stock), or services (limited exceptions to this rule). Further, the stocks that the taxpayers receive are limited to a certain extent and cannot be freely traded in the secondary market.
- From August 10, 1993, until the time the taxpayer’s stock is issued, the corporation’s total gross assets must have a tax basis that is less than $50 million at all times.
- In some cases, QSBS treatment can retroactively be eliminated after redemption.
How can startups qualify for QSBS?
Every startup and early-stage investor should be familiar with qualified small business stock or QSBS. With the help of this tax exemption, companies need not pay capital gains taxes to the federal government on selling their eligible shares. The startup or private company must adhere to the following requirements to qualify for the QSBS tax treatment –
- Receive shares in the company when a company has gross assets of $50 million or less
- Company is set up as C corporation
- Startups need to manufacture or create services.
- Hold your stock for at least 5 years
Get a 409A valuation with Eqvista!
The QSBS tax benefits are a highly advantageous method to raise capital for an early-stage startup or a small private company. It works in favor of both the corporation as well as the investor backing the company. In the case of a small private company or an early-stage startup, you should get your 409A valuation done to offer your company’s equity to investors. At Eqvista, with the help of qualified valuation experts and professionals, you can get a correct appraisal of your company’s private stock. So, without a 409A valuation, a company won’t qualify for the QSBS tax exemption. So, start your journey of getting a 409A valuation with Eqvista.