This one weird trick could save you $2,000,000 in capital gains taxes!
A crash course on Qualified Small Business Stock
One of my favorite topics in startup compensation is qualified small business stock (QSBS). It blows my mind how few people are aware that this thing exists in the US tax code, especially since it actually affects quite a lot of people in the tech industry. Essentially, if you hold QSBS in a tech startup, when you go to sell it, you’ll pay $0 in federal capital gains taxes. Yes, that’s a zero.
Disclaimer: I’m definitely still not a lawyer or a financial advisor, so don’t call me if you get audited for tax fraud.
No taxes? I’m listening
Ok, to be clear, it’s not quite no taxes, but no federal taxes. But yes, qualified small business stock, outlined in U.S. Code § 1202(c) provides that if you hold qualifying stock for five years or more, you can exclude 100% of the capital gains from your taxes on the first $5,000,000 in gains ($10,000,000 if you’re married). Holy crap, that’s a big windfall.
If you live in one of the states that doesn’t have state income tax, it means those gains are actually completely tax free. If you happen to live in California, it’s not quite so simple, and you’ll still owe taxes there, as California doesn’t recognize a QSBS exclusion (it used to, but that law was repealed, in case you get confused Googling about it, as I did). California also doesn’t have a differentiation between long-term capital gains and short-term income, so you just get taxed at marginal rates, so 🤷.
Do I have QSBS?
The tough thing with QSBS is that there’s a whole bunch of questions that you need to ask in order to ensure your stock qualifies, and some questions are easier to answer than others. Let’s go down the list, and answer them one-by-one, from easiest to hardest:
1. Have you owned your stock for 5 years or more?
Thankfully, this is a very easy question to answer, if you’ve been keeping diligent records of your stock exercises, and really I include this at the top primarily for the purpose of making it clear that your stock might qualify once you’ve held it for five years. This is the most critical question to ask, because you don’t get the tax exclusion unless you’ve held the stock for five or more years (five years and a day counts). If you’ve held for less than five years, your stock will qualify once it hits the five year mark, assuming it qualifies under all the other checkboxes.
For employees/founders: If you were a really early employee (or founder) of a software company, and especially if you received a restricted stock award (not to be confused with ISOs or RSUs), or early exercised options as an early employee, there’s a damn good chance that you’re holding stock that will be considered QSBS after five years. You’ll probably want to check if you check all the other boxes before you sell any of your stock, to see if waiting to sell could actually save you a lot of taxes.
For investors: If you were an angel investor, or invested directly into a company, especially via a SAFE as a seed investment, there’s a good chance you’re holding qualifying stock, but that it’s really important that you keep an eye on that five-year timer. It doesn’t start when you execute the SAFE! The SAFE is an agreement to purchase equity later, but you don’t actually own that equity yet...the five-year timer starts when the SAFE converts to equity, typically in the next priced round (usually the A round).
2. Did the company ever raise $50M or more before you purchased the stock?
My question here is actually slightly different than the qualification criteria, which states that the aggregate gross assets of the business must have been less then $50,000,000 at all times before and immediately after the stock issuance. Basically, if you exercised stock, immediately before a big financing raise that brought the company coffers up past $50M, you don’t have QSBS. If you’d been exercising periodically, it might be the case that some of your shares are QSBS and some are not, so it’s really important to keep good records, and also be aware that you’ll need to specifically identify which shares you’re selling when you do sell. That “immediately after” part isn’t actually defined in the tax code, so if you’re looking at the calendar to count the days, you’re best off talking to a tax attorney who deals in startup stuff.
A funding round is the most likely reason your company would have more than $50M in gross assets, but it’s definitely not the only reason. For example, if you were a super early employee at a company like Lime, or work for a company that holds some sort of inventory, if that inventory pushes the gross assets above $50M, that could also prevent your stock from qualifying.
3. Does your company spend the vast majority of its money on building and selling software?
Again, not the actual legal qualification. The tax code actually requires that the business spend 80% or more of its assets in “active conduct of 1 or more qualified trades or businesses.” Digging into the definition of qualified trades leads roughly to the following set of things that definitely don’t qualify: professional services businesses, banking/finance/insurance companies (I’m not sure where Plaid, which is more of a finance data broker would fall on this), farming businesses, or hotels/motels/restaurants. I’d guess that your UberEats and DoorDashes fall on the side of qualifying, since they’re really a tech company enabling restaurant delivery, rather than actually being in the business of restauranting, but again, great topics for a tax attorney.
With that said, if you work for a company that builds a SaaS product or the thing that your company sells is primarily a software product, your business definitely qualifies.
4. Did you buy your stock directly from the company?
The text of the tax code states that, in order for stock to qualify, it must have been acquired “at its original issue (directly or through an underwriter).” Conveniently, nowhere does the tax code actually say what it means to have been “acquired at original issue”. Thanks, legislators.
If you go deep into an internet hole, you’ll find there’s a bit of disagreement around what this actually means, but I take it to mean: “did you buy the stock directly from the company?”
For employees/founders: If you paid money to the company to exercise ISOs, or if you received a restricted stock award, and you bought the shares outright at the start of your employment, I believe that this qualifies as acquiring the stock at its original issue.
For investors: Things are pretty straightforward here, if you got your stock through an equity round of financing, or as a conversion to equity from a previously-executed SAFE agreement or convertible note. However, it gets a little weirder if you’re an LP in a fund, or purchasing through an SPV (if you’re not familiar with the term SPV, don’t worry about it for now, and maybe this will be a different post some other day). SPVs are technically pass-through entities, so I believe that you can purchase qualifying shares as an LP through a fund, but I haven’t tested this theory, and I definitely wouldn’t do so without legal advice.
Your stock definitely does not qualify, if you purchased it through any sort of secondary offering, or from another shareholder who is not the company.
5. Did the company ever buy back stock from investors or employees?
If you’re a pretty early-stage employee, this is probably not an issue for you, but this might actually be problematic for employees at companies where there was a bad split between founders or the company with its investors. I would imagine this most likely happening if the company has repurchased a significant amount of stock, either as buybacks to inflate the stock price and reduce dilution, or to buy back large amounts of stock from a departing investor or founder (I’m not sure on this latter point, and if you know more than me, I’d be curious to know the actual answer!).
6. Is the company a C corp?
This one is actually really easy to answer, but it’s unlikely you’ll be able to get the answer without going and asking someone in Finance or Accounting at your company. They’ll likely know off the top of their head, though.
I’m pretty sure I have QSBS! What do I do??
CYA. And get an accountant and a lawyer. If you’re going to go out and claim that you have qualified small business stock, you best have proof and documentation to show the IRS. The challenge here is that the definitions are hazy in some areas, so tax attorneys will help, and honestly, some of it will require best-effort reporting. The actual mechanics of reporting it is easy, and you can do it in TurboTax or whatever, though probably if you’re selling QSBS, you should have an accountant.
One approach that I’ve used is to ask my finance team to provide a letter on company letterhead attesting to as many of the qualification criteria as I can get them to. Ideally, and at the least, that the company is a C-corp, has less than $50M in assets, makes software, etc. This really is going to only matter if you get audited, but if you get audited, you definitely don’t want to be caught without this documentation.
Double or nothing! The 1045 Exchange
If you’ve ever purchased investment real estate, you may have heard of the 1031 Exchange. This is essentially a technique that investors will use to defer taxable gains, by selling one property, and “exchanging” it for another property that is considered a similar asset by the IRS. There are some restrictions around this, however, in that the exchange has to happen within a relatively short period of time to leverage the tax benefits.
QSBS is actually eligible for a similar type of rollover called a 1045 exchange or 1045 rollover. If you buy more QSBS within 60-days of selling appreciated QSBS, you can purchase QSBS in another entity and rollover the gains from your sale to defer the taxes. So if you’re an angel investor, and receive sale proceeds from a secondary sale or through an acquisition or other liquidity event, you can reinvest the gains into a different seed-stage or early-stage company that meets the QSBS criteria, and defer the taxes on your sale until the next one becomes liquid. This is also potentially useful if you’re an executive employee at a company with QSBS, and join another early stage company, and have the option of early exercising and filing an 83(b) for an offered equity package.
This is however, a complex tax maneuver (and I’ve never done it, so I have limited expertise to draw on here), so should definitely not be attempted without the assistance of a tax attorney and accountant.
If you’re a founder, early-stage employee, or angel investor in a software company, there’s a very decent chance that you might have shares or options that will qualify as QSBS, and it’s a good idea to figure that out early, so that you can be thinking about that five-year timer. For me, this is also a useful way to justify taking the risk on early exercising options, to get that timer started early (if you do this, you must make sure to file an 83(b) election, to let the IRS know you are recognizing the income from the purchase of the stock ahead of vesting).
It’s also worth mentioning that “early-stage” can be very relative. That timeline could be quite a few years, depending on how fast a company is growing, and how much money they raise. These days, oftentimes the B- or the C-round of funding will push over that $50M mark, and almost certainly is the case by the D-round. As an example, one company I worked for crossed over from qualifying to not qualifying somewhere in the 40-50 employee range, and about 3-4 years after founding. I’ve also worked for companies where even north of 60 or 70 employees, I believe the stock still qualified. It all depends on growth trajectory, and financing.
Moral of the story is that this is a useful area to know about in the tax code if you happen to be a frequent startup-er, and hopefully can save you a few tax bucks down the road.