Qualified Small Business Stock and the Capital Gains Exemption

As Benjamin Franklin famously stated, the only certainties in life are death and taxes. But that was before the qualified small business stock, or QSBS exemption, came into existence.

If you're facing a potential taxable event from shares you acquired in a private company, understanding the ins and outs of the QSBS exemption—also referred to as Section 1202 of the Internal Revenue Code, or IRC—just might ease the pain of one of life's inevitabilities.

Section 1202 requirements

If you're a founder, angel investor or employee of a successful early-stage company, it's important to understand certain qualifications that might help you protect up to $10 million—or 10 times your cost basis, whichever is greater—from federal taxes.

In order to benefit from this exemption, you must meet several key QSBS requirements. Specifically, you must have held stock in a qualified small business for at least 5 years. As it relates to this section of the tax code, a qualified small business is defined as one or more of the following:

• A domestic C corporation
• An entity with cash and other assets totaling $50 million or less on an adjusted basis, where the taxpayer acquired the stock on original issuance from the corporation.
• Any business other than services firms like health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial or brokerage services; banking, insurance, financing, leasing, investing or similar businesses; farming, mining and other businesses involving natural resources; or an operator of a hotel, motel, restaurant or similar business
• An entity that's actively running a business, where at least 80% of the assets of the firm must be used to actively run the business instead of for investment purposes

The other key requirement is to understand when and how you acquired the stock. This small business tax exemption has been in place since 1993, but it has since undergone a few improvements. Here's a breakdown of the actual savings based on the date you acquired shares.

A real-world example

Let's say Mr. Jones started ABC Company in January 2009 using $10,000 in cash. In October 2010, Ms. Doe—an early employee—received 200,000 options exercisable at $0.05 per share, which she immediately exercised. In July 2012, Mr. Lee made an investment of $500,000 when the value of the firm was $5 million.

In June 2016, the company was acquired for $100 million. Let's assume Mr. Jones received $10 million, Ms. Doe received $2.5 million and Mr. Lee received $15 million. However, Mr. Jones' effective tax rate—assuming alternative minimum tax, or AMT—is 16.88% on his profits. Ms. Doe, on the other hand, has an effective federal tax rate of 0% on her gains.

Because Mr. Lee hasn't met the 5-year holding rule, he decides to use $10 million to invest in three other startups and writes them checks within 60 days of the payout. With the remaining $5 million, he pays long-term small business capital gains at 20% plus a net investment income tax of 3.8%. If and when the other investments pay him back, his principal in these transactions will have an effective tax rate of 0%, and any gains may qualify for QSBS treatment.

In order to qualify for this potentially powerful small business capital gains exemption , you must have acquired the stock directly from the issuing company for either cash, services or property—including intellectual property. Shares acquired through a secondary transaction don't qualify for QSBS benefits. You also must also be a non-corporate taxpayer and shareholder to qualify for the QSBS exemption.

The finer points

Certain redemptions can potentially disqualify some stock purchases from QSBS treatment. Specifically, redemptions in excess of 5% of the aggregate value of a corporation's outstanding stock within 1 year either before or after the purchase of stock will disqualify it from QSBS treatment. Redemptions from a related person of the holder within 2 years either before or after a stock's purchase will also disqualify it from QSBS treatment. Typically, redemptions from departing employees don't disqualify purchases from QSBS treatment.

Section 1045 of the IRC is also critical to understand. This pertains to the ability to achieve QSBS treatment on shares that haven't been held for a full 5 years. Under this rule, if you've owned stock that qualifies as QSBS for more than 6 months but less than 5 years at the time of liquidation, you can roll the stock over into another qualified small business to maintain its treatment and receive the preferential exemption after 5 years.

Common QSBS questions

Here are answers to some common questions related to the QSBS exemption.

• What happens when you own QSBS that's acquired for stock that isn't QSBS? In this case, the stock retains its treatment but the gain eligible to be exempted under Section 1202 is capped at the time of the exchange. All stock received via gift, death or distribution also retains its QSBS treatment, and the holding period of the original owner is tacked on to the subsequent owner.
• What if you're a founder whose company is currently an LLC? If the asset requirement can be met, you may consider converting from a limited liability company, or LLC, to a C corporation. Just make sure to consult with your tax advisor to make this a qualified transaction. Your holding period then begins at the time your shares are acquired from the C corporation.
• What if you're using a convertible note or simple agreement for future equity, or SAFE, instrument? The holding period and asset requirements don't begin until conversion is completed. This could leave you susceptible to receiving stock that's not eligible.

QSBS considerations

If you're using stock to gift to a charitable organization or donor-advised fund, consider avoiding using stock that qualifies for QSBS unless it's over the $10 million cap. It's often better to use other low-basis stock in this case, which would otherwise be heavily taxed to maximize your after-tax benefit.

If you're an employee of an early-stage company, consider selling while the company is still a qualified small business. Be aware, however, that selling directly before raising capital may disqualify the stock from QSBS.

It's also important for companies to document QSBS status of their newly issued stock at each round of financing. Whether you're a founder, investor or employee and want to take advantage of QSBS, also be sure to document purchases so you have the correct dates at the time of liquidity.

Most importantly, be sure to discuss your options with your financial adviser and qualified third-party tax advisors before making any decisions. The QSBS exemption benefit could potentially save you from a significant tax bill that you—and Benjamin Franklin—might have thought was inevitable.