Qualified Small Business Stock (QSBS): The tax break founders need to know about

Surprisingly few founders know about it, but qualified small business stock (QSBS) is a type of stock issued by early-stage companies. It allows founders and early investors to potentially receive a 100% exemption on federal capital gains taxes, up to $10 million or 10 times their original investment amount (whichever is higher). The QSBS rules can be found in Section 1202 of the Internal Revenue Code.

If your company qualifies, it can make your company more attractive to investors and potential employees – also, you’ll be able to benefit from the tax break yourself.

In this article, we’ll cover how QSBS can help you as a founder and what you need to do to qualify for it.

How can QSBS help you as a founder?

Your investors could pay less federal capital gains tax when they sell their stock

For federal tax, your investors can exclude 100% of the gain up to $10 million, or 10 times their original investment value of the stock, whichever is greater. For example, if they make an investment of $500,000 which qualifies as QSBS, and later sell the stock for $5.5 million, they can exclude the entire gain of $5 million when calculating their federal capital gains tax (effectively saving $1,190,000 based on current federal capital gains tax rates of 20% plus the 3.8% Medicare surtax for high earners). By telling potential investors about this tax benefit, you’ll make your company more attractive to them. We’ve written this article on QSBS for investors which you can share with them. It covers the benefits of QSBS for investors and what they should do to qualify.

Your investors could pay less state capital gains tax when they sell their stock

Many U.S. states conform to the federal QSBS rules, offering the same tax benefits at state level. For example, Delaware, New York, Colorado, and Connecticut conform to QSBS. If your investors are in a state that conforms to QSBS, they can also benefit from state tax exemptions, making investment in your company even more beneficial. Not all states conform to QSBS (for example, California doesn’t).

You could pay less federal and state capital gains tax when you sell your stock

When you eventually sell your stock (for example, in a sale of your company), you can exclude 100% of the federal capital gain up to $10 million. If you’re in a state that conforms to QSBS (like Delaware, New York, Colorado, or Connecticut), you could get similar state capital gains tax benefits.

Your employees could pay less federal (and state) capital gains tax when they sell their stock

If you are planning to incentivize your employees with stock or stock options, they could also benefit from QSBS tax relief. If you point out this benefit to any potential employees, it makes joining your company more appealing. Read the FAQ below titled “Do employee stock options qualify as QSBS?”

You could pay less inheritance tax

In some circumstances, you can transfer the QSBS tax benefit into trusts or to heirs, meaning your family can inherit the stock with no immediate tax consequences.

How can your company qualify to issue QSBS?

There are a few requirements you need to satisfy to issue QSBS. These should be achievable for most startups, though.

1. The company must be a C corporation: Only C corporations are eligible to issue QSBS – S corporations and LLCs do not qualify (foreign corporations are also not eligible). Most startups are set up as Delaware C corporations, so this shouldn’t be an issue. If you’re not set up as a C corporation, check out the FAQs below where we explain what you need to do.
2. The company’s assets must not exceed $50 million: The company’s gross assets, including cash and other assets valued at their original cost (plus any investment that’s being raised at the time) must not be more than $50 million at the time the stock is issued. Most companies at the start of their journey won’t have more than $50 million in assets, so this should be okay.
3. The company must be an active business: At least 80% of the company’s assets must be used in the operations of its qualified business, which excludes activities that generate passive income (like owning property and collecting rent). For startups raising investment to grow their business in a normal way, this requirement should usually be satisfied.
4. The company must not be in an excluded industry: Service businesses like healthcare, law, and financial services generally can’t qualify for QSBS. A full list of excluded businesses can be found at Internal Revenue Code Section 1202(e)(3).
5. You must hold the stock for five years to benefit from the tax relief personally: To fully benefit from QSBS tax relief personally, you’ll need to hold the stock for at least five years before it’s sold. If your investor or employee wants to benefit from the tax relief, they’ll also have to hold the stock for five years. If you’ve been raising with SAFEs or convertible debt, check out the FAQs below where we explain how this impacts the five-year hold requirement.
6. You must receive the stock from the company: You must have been issued stock directly from the company (both common and preferred stock can qualify for the relief). As a founder, this usually won’t be a problem as you’ll have been issued stock from the company. If your investors or employees want to benefit from the tax relief, they’ll have to have been issued stock directly from the company.

FAQs for founders

Here are some questions you (or your investors) might be asking.

How can I assure my investors that my company qualifies to issue QSBS?

It’s important to check you qualify before issuing QSBS to your investors, your employees or yourself. Your investors might expect representations and warranties in the investment documents that state the stock they’ll be receiving meets QSBS requirements.

What do my investors need to do to benefit from QSBS?

We’ve written this article on QSBS for investors which you can share with any current or potential investors. It covers the benefits of QSBS and what they should do to qualify.

I didn’t initially set up my company as a C corporation. Can I still benefit from  QSBS?

Only C corporations can issue QSBS, but a company can convert from another structure (such as an LLC or an S corporation) to a C corporation and issue QSBS (as long as the other criteria are met).

Also, if you were issued stock before conversion to a C corporation, you could still benefit from QSBS on that. The gains on that stock before the conversion won’t qualify for QSBS. But gains on the stock after the conversion can qualify for QSBS (provided the company meets the other requirements).

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 $30 million. In this case, QSBS could apply to the $25 million gain that accrued after the conversion, but not to the initial $5 million from when the company was an LLC.

Can QSBS be held by a company or does it have to be held by an individual?

QSBS is designed to be held by individuals. It can be owned by entities like trusts, partnerships, and S corporations, but there are limitations and additional requirements. For example, for trusts, the tax benefit can only apply to the beneficiaries if they were beneficiaries at the time the stock was issued. You can find more about QSBS being held by entities at Internal Revenue Code Section 1202(g).

Does QSBS benefit apply to stock that’s transferred by another stockholder (for example, secondaries)?

No, you do not get any QSBS benefit if you are transferred stock from someone else. The QSBS benefit is only available for stock acquired directly from the company.

If I’m issuing stock as part of a fundraise, does the $50 million limit for QSBS include the money I’m raising?

Yes, the $50 million gross assets limit for QSBS does include the funding you’re receiving. So, if the company’s assets, including the new funds, are more than $50 million, the stock will not qualify as QSBS. But if you issue stock that qualifies as QSBS, and further down the line the company’s gross assets exceed $50 million, this doesn’t affect the QSBS status of the stock issued before. In case a fundraise will take you beyond the $50 million limit, you can deal with this by issuing stock in tranches. The company can issue a first tranche of enough QSBS to keep you below the $50 million limit. Then, a day or more after, it can issue a second tranche of non-QSBS which can take you above the $50 million limit. This ensures you can issue as much QSBS as possible without risking its eligibility.

Our company’s assets exceeded $50 million but have now fallen below it. Can we still issue QSBS?

No, if the company’s gross assets exceed $50 million at any point, it can no longer issue QSBS.

Does a SAFE qualify as QSBS?

SAFEs can potentially qualify as QSBS, but there is some uncertainty around this. QSBS can only apply to “stock,” and it’s not certain whether the Internal Revenue Service (IRS) classifies a SAFE as “stock”. This distinction is important because of the requirement to hold QSBS for five years to achieve the full benefit. If a SAFE is considered “stock,” the five-year clock starts from the moment the investor enters into the SAFE. If not, the clock only starts from when the SAFE converts to equity in the company at the point it’s issued to the investor. So, it depends on how the IRS classifies it. The Y Combinator SAFE, for instance, is intended to be treated as “stock,” but this characterization isn’t binding on the IRS. If you want to ensure your SAFE investors get QSBS relief sooner, you should consider converting the SAFEs into stock as soon as possible. This way, you reduce the uncertainty around whether the SAFE itself is treated as “stock”. In any case, it’s always worth consulting with your tax advisor for their view on the knock-on effects of treating SAFEs as “stock” for tax purposes.

Does convertible debt qualify as QSBS?

Convertible debt doesn’t qualify as QSBS until it’s converted into stock. The five-year holding period for QSBS starts only when the convertible debt is actually converted into stock. As with SAFEs, you could convert the debt into stock to trigger the five-year holding period required for QSBS.

Do employee stock options qualify as QSBS?

No, employee stock options (including incentive stock options, restricted stock units, or other bonus arrangements) do not qualify as QSBS as the IRS does not consider them as “stock”. If any employees with stock options want to rely on QSBS tax relief, let them know that their five-year holding period only begins from when the stock is issued to them following their exercise of their options.

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