Early Stage Startup Series
Today, I’m discussing QSBS, a popular topic with early stage startup founders and early employees because of the potential federal income tax savings when selling QSBS. The Internal Revenue Code states that, if certain requirements are met, an individual who sells QSBS can exclude from federal income tax all of the gain of that sale, up to the greater of $10M or 10X the cost basis of that stock, if the stock was held at least 5 years before selling. This huge federal tax benefit is a big driver for investors and founders and early employees when it comes to holding on and timing the sale of shares of their startup. Note that this is a federal income tax benefit, and does not apply to state taxation of stock sales.
For the stock sale to be treated as QSBS and excluded from federal income tax, all the following requirements must be met:
This requirement seems straightforward, but there are a few parts to this, so let me clarify. First, S Corps don’t qualify, the stock must be issued from a C corporation. You must have gotten the stock directly from the startup, and not from a secondary sale.
Furthermore, options are not stock and won’t qualify here. But, do SAFEs qualify as stock? The answer is maybe, because the IRS hasn’t set a position on this, and many advisors consider it stock for purposes of QSBS, but note that the IRS may take a position on this in the future so don’t assume SAFEs qualify.
The recipient of the stock must be an individual, and not a corporation. Lastly, the stock must have been acquired in exchange for money, property or services, with very narrow exceptions. In the usual case of an investor, founder or early employee, this last requirement won’t be an issue, and usually comes up when stock is transferred from one corporation to another.
The two requirements for qualifying as QSB are written in the statute, and are:
The statute defines “aggregate gross assets” as the total of cash and aggregate adjusted bases of other property held by the company, which can include real estate.
The company has met the active business requirement if at least 80% by value of the assets of the company are used in a qualified trade or business. No more than 10% by value of the assets can be held in stock and securities, and no more than 50% by value of the assets can be held as working capital. In the startup context, working capital is usually the cash raised from investors, but unless you’re a founding team member, it’ll be hard to know if the 50% working capital requirement has been met when you want to sell your stock.
When it comes to a “qualified trade or business”, the code states that professional services businesses such as law, accounting, and consulting don’t qualify, among others. The statute also lists out other businesses that don’t qualify, so check there if you’re uncertain about yours. Generally, tech startups do qualify for QSBS under this requirement.
You must have held the stock for at least 5 years before selling. When it comes to options, the 5 year clock starts running on the date you exercise your options, and NOT the date of grant of the option, because you don’t have any actual stock until the option is exercised.
There are additional exceptions under the statute that I won’t get into here, as they’re really getting into the weeds of QSBS and situations such as corporate re-orgs. If you’re unsure if your stock qualifies as QSBS, it’s best to consult a tax attorney or a CPA with experience in this area. Good luck!
