Many thanks to Alexander Lee and Mark Windfeld-Hansen for their assistance with this post.
Over the past 25 years, the US tax code has given founders and investors a significant tax break. Taxpayers holding qualified small business stock (“QSBS”) may be able to avoid tax on all or part of their gain from the sale of QSBS if certain requirements are met. Because of this, founders should carefully consider qualification for QSBS benefits when forming, operating, and selling their companies.
What is QSBS?
QSBS is stock in a United States C corporation that had gross assets of $50 million or less at all times before and immediately after the issuance of the QSBS and has been actively engaged in a “qualified trade or business.” What constitutes a qualified trade or business is pretty broad, though it excludes certain service businesses (like law, healthcare, financial services and architecture), financial businesses (like banking and insurance), and other specified industries (farming, mining, hospitality and restaurants). While this list is not exhaustive, in our experience many early-stage investments in technology companies meet these requirements and thus stock in many startups can qualify as QSBS.
What are the benefits of QSBS?
If the requirements described below are met, a person holding QSBS may be able to exclude between 50% and 100% of the gain on the sale of their QSBS from US federal, and some states’, income tax. The amount of the exclusion depends on when the holder acquired the QSBS:
- QSBS acquired after September 27, 2010 may qualify for a 100% exclusion.
- QSBS acquired after February 17, 2009 and before September 28, 2010 may qualify for a 75% exclusion.
- QSBS acquired before February 18, 2009 may qualify for a 50% exclusion.
In all cases, the amount of the exclusion is limited to the greater of $10 million or 10 times the holder’s adjusted tax basis in the QSBS that is sold. So, if a person who acquired QSBS after September 27, 2010 has an adjusted tax basis of near $0 in that QSBS (as would be the case if you acquired your QSBS at formation for a nominal amount ) and sells that QSBS for $25 million, the person would only pay capital gains tax on $15 million of gain, rather than the full $25 million. Note that favorable QSBS treatment does not apply to corporations that own QSBS.
What are the major requirements to qualify for QSBS benefits?
There are two main requirements that a holder must meet to take advantage of these benefits.
- With a few exceptions, the holder must have acquired the QSBS directly from the company in exchange for money, property (not including stock) or as compensation for services.
- The holder must have held the QSBS for more than five years at the time of sale.
The company itself must also comply with various rules in order to allow its shareholders to qualify for favorable QSBS treatment. For instance, certain redemptions by the company can cause certain of its stock acquired within specified periods before or after the redemptions to fail to qualify as QSBS. In addition, the company must remain a United States C corporation and actively engaged in a qualified trade or business throughout substantially all of the five-year holding period. Accordingly, decisions on how to organize and operate a company are important for QSBS purposes.
What if a person hasn’t held QSBS for five years?
If a holder sells QSBS before five years, such holder may be able to avoid tax by investing the proceeds from the sale into other QSBS. To take advantage of these “rollover” rules, the holder must have held the QSBS that was sold for more than six months. The holder has 60 days to compete the rollover, and the company into which the holder rolls its gain must be a United States C corporation with gross assets of $50 million or less that is actively engaged in a qualified trade or business for substantially all of the first six months following the rollover. Provided these requirements are met, the holder should qualify for the QSBS benefits described above once its combined holding period in the “old” and “new” QSBS exceeds five years. In addition, if a holder exchanges QSBS for stock that isn’t QSBS in certain tax-free transactions, that other stock will be treated as QSBS to the extent of the gain that would have been recognized at the time of the exchange if the transaction had not qualified as tax-free. As with the rollover provisions described above, a holder may combine its holding period in the “old” and “new” QSBS for purposes of qualifying for the five-year holding period. Note, however, that the holding period in QSBS will be suspended if, prior to completing that holding period, the holder has an “offsetting short position” with respect to its QSBS, including if the holder makes a short sale of its QSBS or acquires an option to sell its QSBS.