How to get up to $500M in federal tax relief

Could you sell your startup for hundreds of millions and pay little to no federal tax? It sounds too good to be true, but under the right circumstances, it’s possible.

Some founders have used a legal tax strategy that takes advantage of Qualified Small Business Stock (QSBS) to significantly (or even entirely) cut capital gains taxes on hundreds of millions of dollars.

In this article, we’ll break down the strategy step by step and explain who it may be right for.

What is QSBS and how does it work?

Qualified Small Business Stock (QSBS) is a tax break under Section 1202 of the Internal Revenue code that allows founders and investors to exclude up to 100% of federal capital gains tax when selling a qualifying C-corporation.

The tax exemption applies up to the higher of:

• $10 million, or
• 10 times your original investment (we’ll call this the ’10x basis rule’).

This means if your original investment was $10 million, you could exclude up to $100 million of federal capital gains tax.

But there are strict conditions to qualify for QSBS. For example:

• The company must have been a C-corp when the stock was first issued.
• The stock must be held for at least 5 years before sale.
• The company must have had less than $50 million in assets at the time of issuing the stock.

To benefit from QSBS, you have to be a C-corp. But starting as an LLC can potentially boost your tax savings.

Let’s break it down.

How does starting as an LLC boost your tax savings?

Most startups incorporate as a C-corp right away. This is typical if you’re planning on raising venture capital.

But some founders start as an LLC first for tax flexibility.

Why? Because LLCs pass losses through to the owners’ tax returns, which can be useful in the early years when a business is unprofitable.

Later, if the company is growing and still under the $50 million asset threshold, it can convert to a C-corp and issue QSBS-eligible stock.

Starting as an LLC means:

1. First, as an LLC, you may be able to offset early losses against your personal income.
2. Then, you can convert to a C-corp, just before crossing $50 million in assets.
3. At that point, the 10x basis rule applies to the company’s fair market value at the time of conversion, not the initial LLC value.

If you time this correctly, this can supercharge your QSBS tax exemption as you build value as an LLC, which acts as your base for the 10x basis rule.

So, theoretically if you convert just as your valuation hits $50 million (but before it exceeds it), under the 10x basis rule, you can get up to $500 million in federal tax relief.

Just know that the gains on that stock before the conversion won’t qualify for QSBS.

For example, say you own 100 units in an LLC, which grow in value to $5 million. Then, the LLC converts to a C-corporation. After the conversion, the company grows further and your stock is sold for $20 million. In this case, QSBS could apply to the $15 million gain that accrued after the conversion, but not to the initial $5 million from when the company was an LLC.

How one founder set up a $400 million tax-free exit

Here’s an interesting example we saw shared on X (via @ankurnagpal). It’s a useful illustration of how this works:

• The founder’s startup began as an LLC. The business grew and reached a valuation of $40 million.
• Then, they converted the LLC to a C-corp. At this point, the company issued QSBS-eligible shares to the LLC members. Since the asset value is $40 million, the 10x basis rule means the founder could later exclude up to $400 million in capital gains.
• Five years later, the company exited for $500 million. Because of the 10x basis rule, the first $400 million was fully exempt from federal capital gains tax under QSBS.

The result? No federal capital gains tax on $400 million, potentially saving the founder over $80 million in taxes.

Should I use this strategy in my company?

While this tax incentive is big, it’s not right for every startup.

Here’s why:

• It’s difficult to time correctly: The QSBS rules require you to convert before exceeding $50 million in assets. If your startup grows too fast, you might miss the window.
• You must hold the stock for 5 years post-conversion: The 5-year holding period resets when you convert to a C-corp. If you exit sooner, you won’t get the QSBS benefits.
• Most venture capitalists won’t invest in LLCs: VCs typically require startups to be C-corps from day one. If you’re planning to raise funding from VCs, this strategy might not be realistic.

So, who is this strategy useful for?

Well, it’s probably best for bootstrapped or angel-funded startups that can delay converting to a C-corp until they’ve grown a lot, and that can scale up close to the $50 million valuation threshold without raising a lot of venture investment.

If you’re thinking about this strategy, make sure you get professional tax and legal advice first. A small mistake could cost you millions in lost tax benefits.

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