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Qualified Small Business Stock

Lesson in Course: Finance at work (advanced, 8min)

I am an early employee at a startup. What do I need to know to save up to $10 million in future taxes?

Eureka!

What it's about: A tax law that gives a significant tax advantage to owners in qualified small businesses.

Why it's important: If our startup qualifies under QSBS, we can avoid paying up to $10 million in capital gains taxes.

Key takeaway: To qualify for the QSBS exemption, our company has to be a C corp and cannot be in a service-based industry.

To incentivize investment and growth in the private sector, lawmakers came up with a favorable tax treatment for employees and investors in small businesses called the QSBS exemption. Qualified small business stock, or QSBS, is a category of equity ownership defined by the IRS for companies below $50 million in assets. 

What is QSBS exemption?

The QSBS exemption is a rule that allows early employees in startups to avoid paying up to $10 million in capital gains to the Federal government.

Proposed QSBS changes in legislation

In September, the House Committee of Ways and Means announced its consideration of federal tax legislative proposals that include reducing the exclusion from income of gain on the sale of qualified small business stock (QSBS) and increasing the tax rate on long-term capital gains, in each case for noncorporate upper-income taxpayers.

Proposed change:

Section 138150 of the draft legislation would eliminate the 75% and 100% gain exclusions for taxpayers with adjusted gross income of $400,000 or more, limiting such taxpayers to the 50% gain exclusion on all shares transacted on September 13, 2021 and after.

Section 138202 of the draft legislation would increase the top long-term capital gains rates from 20% under current law to 25% (increased in each case by the 3.8% tax on net investment income). Furthermore, Section 138206 of the draft legislation would impose a tax of 3% on modified adjusted gross income in excess of $5 million ($2.5 million for married individuals filing separately and $100,000 for estates and trusts), which could increase the rate on long-term capital gains to as high as 31.8%

What does this mean?

If this legislation gets signed into law, 50% of the gains that were covered under the QSBS exemption could be subject to long-term capital gains rates as high as 31.8%. If we had early exercised our stock before September 13, 2021 we should take action to make sure all of the steps are in place to benefit from a 100% exclusion. The difference could be hundreds of thousands of dollars or more in additional tax.

The tax savings almost sounds too good to be true. However, not all companies and startups may receive beneficial tax treatment.

Small businesses must be qualified to receive tax benefits

The first set of qualifications required for the QSBS exemption are listed below.

  1. Business must be an active C corporation (no LLC or S Corporation)
  2. The total assets of the business must be less than $50 million at the time the stock is received
  3. Stock must be held for five years before it is sold

Industry exceptions

There are certain industries and businesses that cannot qualify for the QSBS exemption. These industries are largely service-based industries where consumers or customers are purchasing services rather than actual products.

The following businesses cannot qualify for QSBS exemption even if the business meets the criteria listed above
  • Restaurants
  • Hotel or hospitality
  • Banking or brokerage services
  • Healthcare
  • Law
  • Engineering services
  • Architecture
  • Accounting
  • Actuarial services
  • Performing arts
  • Consulting
  • Athletics
  • REIT
 

The QSBS tax break

QSBS exemption provides significant federal tax breaks

If all three criteria above are met and the industry exceptions do not apply, we are entitled to the following benefits:

  1. Federal tax exemption of 10x our initial investment, or $10 million (whichever is greater)
  2. State tax exemptions of capital gains unless we live in California and Pennsylvania 
    Note: Massachusetts, New Jersey, and Hawaii offer QSBS exclusions on state tax for capital gains with modifications to federal requirements.
 

Actionable ideas

To take full advantage of the QSBS exemption, we need to early exercise. There are risks involved in early exercise and going after the tax exemption. Review the lesson on exercising early and the lesson on qualifying for QSBS to figure out if we qualify for QSBS.

Supplementary materials

The QSBS exemption is covered in detail under Section 1202 of the IRC (Internal Revenue Code).

Here's a fun and quirky video to recap what we've covered so far:

Qualified Small Business Stock
https://www.youtube.com/watch?v=ccBt7wXYmNI

Glossary

What is QSBS exemption ?

An IRS ruling that allows early employees in startups to avoid paying up to $10 million in capital gains to the Federal government as long as they qualify