tl;dr – If you are a small business corporation that issues stock (not units or interests) then your stockholders can be exempt from taxes on the greater of $10 million or 10x your basis (price you paid) if you held the stock for at least 5 years.
Intro
Since August 10, 1993, any stock acquired from a qualified small business can be deemed a qualified small business stock or QSBS.
So what does this mean for you, a small business owner?
For starters, under section 1202 of the internal revenue code, it means capital gains from qualified small businesses are exempt from federal taxes. This commonly referred to as the QSBS exemption.
Under the QSBS exemption a founder, angel investor, VC, or employee of a successful startup could potentially exempt up to $10 million, or 10 times your cost basis (whichever is greater) from federal taxes.
There are some things that you must take into account to determine whether you qualify for the tax benefits for a qualified stock.
How do I qualify as an individual or an investor?
In order to qualify for the QSBS tax exemption as an individual, there are certain qualifications that you must meet.
First – you cannot be a corporate stockholder. Next, you must also have acquired the stock at the original issue, and not from a secondary market such as the stock market. Third, the stock must be purchased with cash, property or accepted as payment for a service. Finally, you must hold the stock for at least 5 years or you won’t qualify for the tax exemption.
Defining a Qualified Small Business
Now that we’ve gone over some of the basic requirements for qualifying for the QSBS tax exemption, let’s talk about the basic requirements for your company to be defined as a qualified small business.
Here are some of the requirements your business must meet to be a qualified small business:
- Recognized as a domestic C corporation
- Cash or assets totaling $50 million or less on an adjusted basis at issuance
- Your business must not be any of the following
- Service firms such as healthcare, law, engineering, architectural, accounting, actuarial science, performing arts, consulting, athletics, financial or brokerage services
- Banking, insurance or similar businesses
- Farming, mining or other natural resource businesses
- Hotel, motel, restaurant, or similar businesses
- You are an entity that is running a business, meaning at least 80% of your assets are used to run the business
Looking at a real world example
Let’s say Karina exits on July 1, 2020 and nets $50 million on the sale. The following are some potential tax implications under various scenarios.
- Karina starts the company on May 1, 2015 but doesn’t issue herself equity until August 1, 2015 because she couldn’t get to it for some reason.
- Karina did not hold her shares for 5 years and therefore does not qualify for the QSBS
- Karina is an investor who purchased a convertible note for $1.2 million in May 2015 that converts into preferred equity in 2017
- She qualifies for the QSBS as the start date is the issuance date of the convertible note, not the date it converted to equity.
- Karina buys shares from a third party in June 2015
- She does not qualify for the QSBS as the stock is not an original issuance
- Karina is a founder who starts her company as an LLC and issues herself units in February 2014 and converts into a C corporation in 2017
- Because Karina converted in 2017 and did not hold the stock for the required 5 years, she does not qualify for the QSBS
Final Notes
The QSBS tax exemption is a powerful tax incentive and one of the reasons why startups are formed as C Corporations rather than LLCs. If you’re a founder, investor or employee of a startup, you might need a professional’s help in navigating this exemption.
You should consult with an attorney as well as a qualified tax professional on this matter.
