Qualified Small Business Stock for Startups
For startup founders and stockholders, navigating the complex world of tax incentives and benefits is essential, but these considerations understandably get lost among the myriad responsibilities that come with running a growing company. One key tax benefit that can significantly impact the financial outlook of founders, stockholders, and investors is Qualified Small Business Stock (QSBS).
QSBS refers to shares of stock issued by qualified small business entities. These entities are typically startups and small businesses that meet certain criteria defined by the Internal Revenue Service (IRS) (more on these requirements below). In an effort to encourage investment in early-stage ventures, the government offers tax advantages to stockholders who invest in such qualified small businesses.
QSBS tax benefits are governed by Section 1202 of the Internal Revenue Code and apply to gains (profits) realized from holding and eventually selling stock in a qualified small business. Conversely, Section 1244 of the Internal Revenue Code provides certain protections and deductions when stock in a small business loses value. We discuss more about Section 1244 in another blog: Tax Relief for Startup Stock Losses.
What are the benefits to stockholders owning QSBS?
QSBS offers the potential for capital gains exclusion. If QSBS is held for at least five years, stockholders may exclude up to 100% of their capital gains from the eventual sale or exchange of that QSBS, leading to significant tax savings.
Even if the exclusion doesn't apply, QSBS still provides a lower effective tax rate on gains, capped at 28%, compared to the ordinary capital gains tax rate, which can be as high as 37%. This reduced tax burden enhances the net returns on investment.
When can stockholders qualify for QSBS benefits?
To qualify for QSBS benefits, several requirements must be met:
Eligible Business: The company issuing the stock must be a qualified small business at the time of issuance. This means that each of the following conditions must be satisfied by the company (among other things).
The company is engaged in an active trade or business.
The company’s aggregate gross assets must not exceed $50 million before or immediately after the stock issuance. This calculation includes the assets of the company and its subsidiaries.
The company must meet certain requirements for substantially all of the holding period after the stock issuance. This includes the business primarily engaging in a qualified trade or business and not being a foreign corporation or a company engaged in certain prohibited activities.
The company must not repurchase substantial portions of its equity from existing stockholders for consideration. Certain repurchases are acceptable, however, including if you are repurchasing shares from an employee in connection with the termination of that employee’s service to the company or the amount of repurchased stock and the amount of money paid for that repurchased stock are below certain “de minimus” thresholds.
Holding Period: The stockholder must hold the QSBS for a minimum of five years to be eligible for the potential capital gains exclusion. The holding period begins on the date of stock acquisition and ends on the date of sale or exchange.
Original Issue: The stock must be acquired directly from the qualified small business in exchange for money, property, or services, rather than purchasing it from existing shareholders. Purchasing stock from an existing stockholder (i.e., a secondary exchange) means that stock cannot be QSBS.
Final Considerations:
To maximize the tax benefits associated with QSBS, both startup companies and stockholders must adhere to the specific requirements established by the IRS. Because these obligations fall on both the company and stockholders, in connection with a stock offering and sale, incoming investors often expect the company to make important representations about the company’s compliance with QSBS rules. For that reason, startups should always discuss QSBS considerations with their attorneys and tax advisors when:
planning the strategic direction of the company,
repurchasing any stock from existing stockholders, and/or
contemplating a stock sale or other investment round.
From ensuring the QSB status and meeting the holding period to verifying aggregate gross assets and post-issuance qualification, careful attention to these requirements is necessary. By meeting these criteria, stockholders can potentially exclude a significant portion of their capital gains from the sale or exchange of QSBS, providing a substantial tax advantage. Consulting with a tax professional or advisor is highly recommended to navigate the complexities of QSBS and ensure compliance with all applicable regulations.
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Valle Legal, PLLC, serves entrepreneurs, corporations, and other businesses at every stage of the company lifecycle: from formation and founding, to financing and fundraising, to merger, acquisition, or other exit. Our clients are based throughout the United States, including the Research Triangle of North Carolina, the Southeast, Silicon Valley, San Francisco, Boston, New York, and Delaware. Our clients operate in a broad range of industries including life science, software, technology, IoT, consumer products, and B2B services. We also represent investors, venture capital funds, and private equity groups who invest in and purchase companies throughout the United States.
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