By: José Padilla
Qualified Small Business Stock (“QSBS”, for short) is stock in a small business that may qualify for a tax exemption pursuant to Section 1202 of the Internal Revenue Code. Under this tax benefit, eligible shareholders are permitted to exclude some or all of the capital gains on QSBS. In other words, it may be possible for founders or investors to deduct up to 100% of capital gains tax upon the sale of QSBS. In order to qualify, certain requirements must be met, including the following main examples:
- The company must be an active corporation incorporated in the United States and taxed as a C Corp;
- The company must operate in an eligible industry (e.g., technology is eligible, but banking, finance, insurance, farming are not);
- The stock was acquired directly from the company for money, property (not including stock), or services;
- The stock was issued to an individual;
- The stock must be held for at least five years to be fully exempt on QSBS gains;
- The tax basis of the total gross assets of the corporation at all times must be less than $50 million.
If your corporation, like most early-stage start-ups, meets the above qualifications (and others), the corporation’s stock is considered to be QSBS.
As you can see, this is important for founders and investors in a startup because gains from selling your QSBS may be entirely exempt from federal income tax!
The company is NOT eligible for QSBS tax exemption if it is a limited liability company (LLC). If one converts the LLC to a corporation, the 5-year holding period begins upon conversion so, as a founder, you can lose precious time if you start off as an LLC.
Thus, if a founder or investor wants the chance at a tax-free sale of stock, it is imperative to keep QSBS in mind when structuring a startup.
Please note that QSBS is complex and there are additional requirements than those listed above.
This article lays out brief summary of Qualified Small Business Stock tax benefit, but please note that this article (1) is not provided in the course of and does not create or constitute an attorney-client relationship, (2) is not intended as a solicitation, (3) is not intended to convey or constitute legal advice, or (4) is not a substitute for obtaining legal advice from qualified professionals.