Founders: Unlock Big Tax Savings with Qualified Small Business Stock (QSBS)

Starting a business is an exciting journey but comes with many risks. Founders work countless hours to create something innovative, and the potential for significant financial rewards is a key motivator. The US government recognizes the value of this risk taking as seen through a tax incentive specifically designed to empower founders of high-growth start-ups: Qualified Small Business Stock (QSBS). 

QSBS provides a  game-changing tax benefit. Each eligible shareholder can potentially exclude up to 100% of the capital gains tax on the sale of stock held at least 5-years, capped at a lifetime limit of $10 million or ten times the original investment, whichever is greater. This benefit translates to a significant boost to financial returns upon a successful exit; 23.8% savings at the federal level and potentially additional state tax savings too.

Who Benefits? The QSBS tax break is generally available to US taxpayers who obtain equity early in a company’s existence (up to the company having $50M in assets).  This could include not only founders, but also early investors, employees, and advisors.  Based on the current financing round levels, this would typically include equity issued prior to Series B.

Meeting the QSBS Criteria: A Roadmap to Tax Savings

To benefit from QSBS, it's important to meet certain criteria that apply to the company, security and the particular shareholder. For business owners, it's key to have a solid grasp of the requirements early on, to ensure things are set up in a way that optimizes for these benefits.  

At the corporate level the company must be taxed as a C-corporation and operate in a “qualified trade or business”, which includes a range of businesses that help drive economic growth and job creation.  Excluded are certain fields that may be viewed as more passive income generating activities (i.e. lending) and businesses where an individual is the product (i.e. a doctor performing surgery on patients).  The company needs to apply most of its assets towards the qualified trade for “substantially all” of the shareholder’s holding period, and certain repurchases of securities could cause shares to lose the QSBS benefits.   

To be eligible for QSBS tax treatment, the shareholder must have acquired the stock directly from the company. Purchasing shares from another shareholder (i.e. a secondary sale) won't meet the eligibility requirements.  

Patience is key! To qualify for the full capital gains exclusion, shareholders must hold onto the stock for at least five years.  But what if you need to sell before the five-year mark? Don't worry—there are still options available to you. You still have an opportunity to reap the QSBS rewards by reinvesting the proceeds into other qualifying QSBS within 60 days via an IRC Section 1045 rollover. 

The Evolving QSBS Landscape

• R&D Capitalization: IRC Section 174 required businesses to capitalize Research & Experimentation expenses instead of deducting them immediately (starting in 2022).  From a QSBS standpoint, this adds assets to the balance sheet and could cause companies to surpass the $50M gross asset threshold (at which the company can no longer issue QSBS stock) quicker than they otherwise would have.  

• IRS Private Letter Rulings (PLRs) on Qualified Trades: To ensure their companies operate in a “Qualified Trade” for QSBS purposes, certain companies have requested Private Letter Rulings (PLRs) from the IRS.  Nine PLRs have been issued to date, all in favor of the companies qualifying, however in early 2024 the IRS announced that they were temporarily suspending such PLRs as they develop a new revenue ruling, procedure or regulation.  

• Founder Liquidity:  As companies have remained private longer, we have seen an uptick in the companies seeking to provide founders with liquidity for portions of their equity.  Given the negative impact “significant stock redemptions” can have on QSBS eligibility, any such transaction should be looked at from a QSBS lens.  Even if such liquidity is not provided through direct stock buybacks, these transactions may risk being viewed as “constructive redemptions”, so founders looking to maintain QSBS eligibility may consider alternative arrangements or advanced planning measures.  

The Takeaway