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.
Generally, businesses that sell services provided by employees do not qualify for QSBS.
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.
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.
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.
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.
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.
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.
Certain employees have used the QSBS rollover to early exercising options at the next startup.
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.