QSBS for investors: Save millions in capital gains taxes on your startup investments

If you invest in startups, you need to know about Qualified Small Business Stock (QSBS). It’s stock issued by early-stage companies that gives you the potential for a 100% exemption on federal capital gains taxes, up to $10 million or 10 times your original investment amount, whichever is greater. You can find the QSBS rules in Section 1202 of the Internal Revenue Code.

If you’re investing in companies that meet the criteria, QSBS can give you substantial tax benefits, which means higher after-tax returns – so, check that the company is QSBS compliant so you can get the benefits.

In this article, we’ll cover how QSBS can help you as an investor and what you need to do to claim the tax relief.

How QSBS helps investors save capital gains tax

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

For federal tax, you can exclude 100% of the gain up to $10 million, or 10 times your original investment amount, whichever is greater. For example, if you make an investment of $500,000 that qualifies as QSBS, and later sell the stock for $5.5 million, you can exclude the entire gain of $5 million when calculating your 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).

You could pay less state capital gains tax when you sell your 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 you’re in a state that conforms to QSBS, you can also benefit from state tax exemptions, making your investment even more tax efficient. Not all states conform to QSBS, though (for example, California doesn’t).

You could defer paying capital gains tax

If you sell your QSBS in one company and reinvest the proceeds into QSBS in another company within 60 days, you can defer paying taxes on the capital gains. Generally, you have to hold QSBS for 5 years to get the full benefit (more on that below). But if you reinvest your QSBS proceeds in this way, the five-year holding period continues from the earlier investment. So, if you hold QSBS in Company A for 2 years and then roll over to Company B and hold it for 3 more years, you meet the 5-year requirement. This rollover allowance means you’ll have the flexibility to make new investments without facing any immediate tax bills.

You could pass QSBS tax benefits to your heirs

In some situations, you can transfer the QSBS tax benefits into trusts or directly to your heirs. This means your family can inherit the stock with no immediate tax consequences – and they’ll benefit from the QSBS exemption on capital gains when they eventually sell the stock. This offers better tax savings in the long run.

You could benefit from ordinary loss treatment with QSBS

If you sell QSBS at a loss, it can be treated as an ordinary loss rather than a capital loss. This means you can deduct it from your regular income, potentially lowering your overall taxes more effectively than if it were considered a capital loss.

You could receive Alternative Minimum Tax (AMT) relief

AMT makes sure that individuals and companies pay a minimum amount of tax, even after deductions and exemptions. Normally, capital gains relief can impact AMT calculations, but the QSBS exclusion also applies to AMT – this can give you an extra tax relief.

How to qualify for QSBS tax relief

There are a few requirements you (and the companies you’re investing in) need to satisfy to qualify for QSBS. For most startup investments, these should be achievable.

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 the company’s not set up as a C corporation, check out the FAQs below where we explain what they 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 again, 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 you’re investing through 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). This means you don’t get any QSBS benefit if you acquire the stock through a secondary market transaction (for example, if you buy it from another investor​).

FAQs for investors

Here are some questions you might be asking.

How can I be assured that my investment qualifies for QSBS?

It’s important to check that the company qualifies to issue QSBS before receiving stock. You could request representations and warranties from the founders in the investment documents which state they comply with the QSBS requirements. We’ve also written this article on QSBS for founders which you can share with companies you’re interested in investing in – it covers what they need to do to qualify.

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 pass-through 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 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’re a SAFE investor and want to ensure you 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.

I’m a non-US resident. Can I benefit from QSBS as an investor?

Not unless you’re subject to US capital gains tax (for example, this could happen if you have a permanent establishment in the US). So, if you’re a foreign investor and aren’t required to file a US federal income tax return, you can’t take advantage of QSBS tax relief. You should consult a tax professional to understand your specific tax obligations.

The company I’m investing in didn’t initially set up as a C corporation. Can it still issue QSBS?

Only C corporations can issue QSBS. But the company can convert from another type of structure (such as an LLC or an S Corporation) to a C Corporation to be able to qualify for QSBS. The QSBS benefit will only apply to stock issued after the company converted to a C corporation. For example, if an LLC was set up and you were issued 100 units, then it converted to a C corporation and you were issued 100 more shares of stock, the initial 100 units you received when the company was an LLC will not qualify as QSBS.

If the company I’m investing in is raising funds, does the $50 million limit for QSBS include the new investment?

Yes, the $50 million gross assets limit for QSBS does include the funding the company receives. If the company’s assets, including the new investment, are greater than $50 million, the stock will not qualify as QSBS. But if you’re issued 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. To deal with a fundraise that might push assets beyond the $50 million limit, the company can issue stock in tranches. It can issue a first tranche of enough QSBS to keep it below the $50 million limit. Then, a day or more after, it can issue a second tranche of non-QSBS which can take it above the $50 million limit. This approach lets you maximize the QSBS investment without risking its eligibility.

The assets of the company you’re investing in exceeded $50 million but have now fallen below it. Can it issue QSBS?

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

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