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Qualifying for QSBS

Lesson in Course: Finance at work (expert, 5min)

QSBS allows us to avoid paying taxes, but how do we know if we qualify?

Eureka!

What it's about: The qualifications required of a startup to benefit from QSBS exemption.

Why it's important: Not all startups qualify for QSBS, and for those that do the window of time to take action is small.

Key takeaway: The company must be a C corp, conduct business outside of the exception list, and have under $50M in assets.

Understanding when QSBS applies and when to early exercise can mean a huge difference with our potential payout if the company we work for becomes successful. The rules are clear on tax exemptions for QSBS, but what does it mean for us and where do we find the information? Let's step through a set of five basic qualification steps that we can ask ourselves. 

Step 1: Does our line of business qualify?

Starting out, we need to confirm that our company isn't on the industry exception list.

QSBS companies have to provide an actual product

Generally, businesses that sell services provided by employees do not qualify for QSBS.

Exception list
  • Restaurants
  • Hotel or hospitality
  • Banking or brokerage services
  • Healthcare
  • Law
  • Engineering services
  • Architecture
  • Accounting
  • Actuarial services
  • Performing arts
  • Consulting
  • Athletics
  • REIT
More on healthcare exception

On June 25, 2021, the IRS released Private Letter Ruling (PLR 202125004), addressing whether certain Healthcare companies can qualify for QSBS. While private hospitals and dentists sell services and are excluded from QSBS, certain healthcare companies that provide a tangible Class of Products are eligible for QSBS. This included medical manufacturing companies, or health tech companies. Read more about this letter here.

Companies that conduct any business found on the exception list cannot benefit from QSBS. 

Step 2: Is my company a C corp?

The second question to ask ourselves is whether our company is a C corp. QSBS only applies to C corp company structures and, LLCs and S corps do not benefit from QSBS.

Most venture capital-funded startups are C corps

What if we don't know? The good news is that most companies are C corps—anything with an Inc is a C corp. If we work in a venture capital-funded startup, it's almost always a C corp. If we can't find it on our company's marketing material, we should refer back to our workplace onboarding paperwork, including the I-9, W-4, or offer letter to double-check for the Inc. In addition, our HR or legal team should also be able to provide this information.

Step 3: Does the company have less than $50 million in assets?

QSBS exemption is only extended to small companies with less than $50 million in assets.

Very early startups are likely to have less than $50M in assets
What is Asset?

An asset is the sum of equity and liabilities on a financial statement called the balance sheet of a company.

For most tech startups, the total amount of venture capital funding serves as a good proxy for the $50 million asset amount. Since tech startups operate with minimal appreciative assets and minimal debt, the total funding amount (equity) often equals the value of assets. If the startup has raised less than $50 million in funding, then there's a good chance the company qualifies. The executives or finance department can provide a copy of the most recent balance sheet and should be able to answer if the assets total more than $50 million. Either way, we should always double-check with management. 

Asset disqualification

Once the company exceeds $50 million in assets for the first time, the company can no longer qualify for QSBS exemption even if the total assets fall below $50 million in the future.

If management told us that the assets are below $50 million, we should always ask as a follow-up if the assets have ever been above $50 million in the past.

Step 4: Can we afford to early exercise?

QSBS exemption requires us to hold the shares for at least 5-years before selling. This countdown doesn't start until we hold the actual stock in the company.

Depending on when we join the startup, exercise costs are high

 

The equity grants we receive at work are often options, or the contractual right to purchase company stock. These options are not the same as the stock or RSAs. To hold the stock in a company, we need to exercise our options by paying the strike price. In some instances, for QSBS exemption, it makes sense for us to early exercise all of our options (regardless of vesting) so that we hold the stock before the assets of the company creep over $50 million.

 

Step 5: Can we afford to wait 5 years?

Life happens and there might be a liquidity event that happens before our 5 years holding period when we need to sell. Selling before our 5 year holding period is up will result in us owing capital gains tax on all of the stock.

Opportunity cost of life can change plans

While this outcome is not desirable, the silver lining is that we may not lose all of our tax benefits due to a QSBS rollover

What is QSBS rollover?

A tax rule that allows owners of QSBS selling shy of 5 years to avoid paying taxes. The tax benefits for QSBS exemption are retained if the proceeds from the sale are invested in another QSB within 60 days.

Certain employees have used the QSBS rollover to early exercising options at the next startup.

Actionable ideas

If our company qualifies for QSBS exemption, and we can afford to early exercise, we will need to double-check with a tax accountant and our company to prepare the right paperwork. This includes filing an 83(b) election to the IRS. If you feel like you need help, reach out to the team at Archimedes.

 

Glossary

What is Asset?

An asset is the sum of equity and liabilities on a financial statement called the balance sheet of a company.

What is QSBS rollover?

A tax rule that allows owners of QSBS selling shy of 5 years to avoid paying taxes. The tax benefits for QSBS exemption are retained if the proceeds from the sale are invested in another QSB within 60 days.