This article was originally published on Forbes.com on August 5, 2019. Written by: Peyton Carr
Company founders and venture capitalists (VCs) alike know that investing in early-stage businesses keeps our economy vibrant and produces jobs — and also involves significant risk. What many often overlook is a tax benefit that can help founders, investors and early employees retain millions of dollars of wealth.
In our extensive work with founders and early-stage employees of venture-backed companies, we are consistently surprised at how few individuals are familiar with the qualified small business stock (QSBS) exclusion. It allows people who own shares to potentially avoid up to 100% of the capital gains taxes incurred upon selling their stake. How does 0% tax sound?
We were recently introduced to a founder whose company was being acquired, and she wanted to do some financial planning to understand how her personal balance sheet would look post-acquisition. In this situation, we collaborated with her corporate counsel and accountant to obtain a QSBS representation from the company and modeled out the founder’s effective tax rate.
Here is how this played out. She owned $5 million dollars of shares in what we’ll call “XYZ Co.,” which met the criteria for qualifying as Section 1202 stock. Her cost basis was $5,000 when she acquired the stock in October of 2012. A few months after satisfying the five-year holding period, a publicly traded company that we’ll call “Big Co.” came in and acquired XYZ Co. at a significant premium, and her new shares of Big Co. were now worth $15 million. When the trading restrictions were lifted and she could sell her Big Co. shares, the first $10 million of her capital gain was 100% excluded from taxation as a section 1202 gain and the remainder was taxed under the normal rules for long-term capital gains.
The QSBS exclusion, part of Section 1202 of the Internal Revenue Code, spells out how gains on the sale of a qualified small business may be protected from taxation. Generally, upon a sale, business owners and investors who meet certain conditions can exclude the greater of $10 million or 10 times the basis of the initial investment from taxation. Owners and investors who take the time to seek advice on whether and how they can qualify may find themselves on the receiving end of a generous tax windfall.
I recommend you do extensive record-keeping as it relates to QSBS. Any detail, whether it be a letter, email communication or other from the company or counsel where it’s stated that the company is 1) a qualified small business as of a certain date, and 2) that the company is below the $50 million-dollar gross asset cutoff is very helpful when you claim your QSBS. I encourage our clients to engage in these conversations and get documentation early on if possible. This makes your life much easier.
Of course, there are always terms and conditions. A lot of them. To use the exclusion, owners and investors must have held the stock for at least five years, and it must have been issued after August 10, 1993, and, ideally, for a 100% exclusion without any AMT add-back, after September 27, 2010. The stock must have been issued by a domestic C corporation, with no more than $50 million in gross assets when the stock was issued. The company must use at least 80% of its assets in an active trade or business with some exceptions, such as certain professional services, finance, mining/natural resources and hotel/restaurants.
Additionally, many states, such as California, do not conform or follow the federal tax treatment of the QSBS. Some of the common pitfalls that may cause owners and investors to become ineligible for the exclusion include not paying enough attention to recapitalization or redemptions of stock owned by related persons, such as siblings, spouses and even other partnerships or failing the gross-asset test by holding excessive amounts of cash and other non-qualified assets in the company. And while S corporations have traditionally had some advantages, this will disqualify you for the QSBS exclusion.
Don’t be that guy! An unfortunate situation we came across was during some extensive pre-sale planning with a group of early-stage employees whose company was being acquired. One of the items on our punch list was to help them determine whether they might qualify for QSBS. And it looked like they would until we learned that, early on in the company’s history, the shares had been bought back by the company, from the brother of one of the founders. It was determined that the redeemed stock, albeit it very small amount in the grand scheme of things, exceeded the “de minimus” amount. Not good. Not only did this disqualify the founder whose brother had redeemed the stock, but it spoiled the rest of the company stock for QSBS purposes.
Roll with it. It’s also important for investors and founders to understand Section 1045 of the Internal Revenue Code and how the tax benefit and holding period can be maintained even if an exit occurs within the five-year window, via a tax-free rollover into another qualified small business. To qualify, the stock must have been owned for greater than six months, and the rollover must occur within 60 days from the sale of the original QSBS. Basically, you can roll your some or all of your sale proceeds into another QSBS eligible small company and defer the tax.
Sixty days is a very short time frame to find another high-quality QSBS eligible investment, and we don’t like the tax tail to wag the investment dog, but it’s good to be aware of this in a situation for when and if the stars align. I’ve seen it work swimmingly.
Evaluating the eligibility of a company, its owners and its investors for the QSBS exclusion requires careful planning and coordination between tax, legal and wealth advisers, but when the upside involves the potential for up to $10 million — and in some situations, more — of gains being exempt from taxation, I’d say the effort is worth it.
The information and opinions provided in this material are for general informational purposes only and should not be considered as tax, financial, investment, or legal advice. The information is not intended to replace professional advice from qualified professionals in your jurisdiction.
Tax laws and regulations are complex and subject to change, and their application can vary widely based on the specific facts and circumstances involved. Any tax information or advice in this article is not intended to be, and should not be, used as a substitute for specific tax advice from a qualified tax professional.
Investment advice in this article is based on the general principles of finance and investing and may not be suitable for all individuals or circumstances. Investments can go up or down in value, and there is always the potential of losing money when you invest. Before making any investment decisions, you should consult with a qualified financial professional who is familiar with your individual financial situation, objectives, and risk tolerance.