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TL;DR: Startup founders and investors can potentially exclude up to 100% of capital gains from federal taxes on the sale of Qualified Small Business Stock (QSBS), resulting in tax savings of up to $10 million (or more in some cases). To qualify, the stock must be originally issued by a C-corporation, held for at least five years, and issued by a company with gross assets under $50 million that operates in a qualified trade or business (e.g., tech, biotech).
Proper structuring, avoiding disqualifying actions like certain redemptions, and strategic planning (e.g., stacking via trusts) can maximize QSBS benefits. However, state tax treatment may vary, and tax rules could change. Consult legal and tax advisors to ensure QSBS eligibility and optimize tax savings.
Consult with a startup attorney today!
The sale of shares or equity in a company is typically subject to either short or long-term capital gains taxes. However, the U.S. tax code offers significant tax savings and benefits to startup founders and investors holding Qualified Small Business Stock (QSBS). Under the right circumstances, QSBS allows founders and early investors to potentially exclude from federal taxes up to 100% of capital gains from their sale of QSBS, subject to a limit of $10 million (or more in some instances), resulting in substantial tax savings.
Continue reading to learn more about QSBS, why it matters to your startup, how to qualify for this key tax benefit, and specific strategies and real-world situations to help you optimize QSBS tax treatment.
What Is Qualified Small Business Stock (QSBS)?
QSBS is a tax benefit available under Section 1202 of the Internal Revenue Code. If specific QSBS requirements are met, stockholders can exclude from federal taxes up to 100% of their capital gains from the sale of their stock in your company, subject to a limit of $10 million (or more in some instances). The primary purpose of the QSBS exemption is to incentivize investment in small, high-growth companies, particularly in industries such as tech, biotech, climate-tech and life sciences.
Key Requirements of QSBS Include:
- The stock must be purchased directly from a C-corporation (i.e., originally-issued stock), with limited exceptions discussed below;
- The issuing company must be a “Qualified Small Business” that meets specific criteria when the stock is issued; and
- To take advantage of this tax exclusion, stock must be held for at least five (5) years from its original date of issuance.
How much you can save on taxes under IRC Section 1202 depends partly on when the stock was issued. For example, stock issued after September 27, 2010, qualifies for the highest tax benefit (i.e., 100% exclusion on gains) under IRC Section 1202. Stock issued between February 18, 2009, and September 27, 2010, qualifies for a 75% exclusion on gains (subject to a 7% alternative minimum tax (AMT) addback). Stock issued between August 10, 1993, and February 17, 2009, qualifies for a 50% exclusion on gains (subject to a 7% AMT addback).
Why Qualified Small Business Stock Is a Game-Changer for Startup Founders and Investors
The founders and investors holding QSBS can receive a significant tax break when your startup has a successful exit—whether through an M&A exit or following an initial public offering (IPO). QSBS also makes early-stage investments more attractive for investors due to the potential for significant federal tax savings upon a successful exit. QSBS is one of the main reasons why most venture capital firms insist on investing in C corporations. To wit, we often see venture capital investors require that the target company convert to a C corporation as a condition of their investment.
$10M+ in Potential Tax Savings:
Stockholders may exclude from federal taxes up to 100% of the capital gains on the sale of their QSBS (subject to certain limitations), subject to a cap equal to the greater of $10 million of capital gains or ten times their original investment amount (i.e., their basis in the shares).
Imagine selling your company after holding QSBS for five years. If you meet the QSBS criteria, your tax savings on that sale could be enormous, reducing your federal capital gains tax to zero in certain circumstances.
How to Qualify for Qualified Small Business Stock: Requirements for the Issuing Company
The company issuing the stock must be a Qualified Small Business meeting specific criteria to ensure its shares are considered QSBS-eligible.
To qualify, the company:
- Must be a domestic C-corporation (LLCs and S-corps do not qualify);
- Cannot have gross assets exceeding $50 million at any time before and immediately after issuing the shares; and
- Must be actively engaged in a “qualified trade or business,” with at least 80% of its assets used in that business.
Some types of businesses are excluded from QSBS treatment, such as those in law, finance, insurance or other professional services. Hospitality and restaurant businesses generally are excluded from QSBS as well. However, suppose your company engages in research and development or focuses on developing a tech, biotech or consumer product. In that case, it likely meets the qualified trade or business requirement under IRC Section 1202.
How to Qualify for Qualified Small Business Stock: Requirements for Stockholders
Stockholders (such as founders and investors) must also meet specific criteria to take advantage of QSBS.
For stockholders:
- They must acquire the stock directly from the company when it is issued for cash, services or property. In other words, they can’t buy shares from a third party and claim QSBS tax treatment.
- They must hold their stock for at least five years to qualify for this capital gains exclusion. There are limited exceptions to these rules, such as in the case of death or some types of mergers and acquisitions, but the five-year holding period is required in most cases.
- Stockholders that are C-corporations themselves may not benefit from QSBS – QSBS only benefits stockholders who are individuals, trusts or other pass-through entities.
Pitfalls to Avoid When Trying to Qualify for Qualified Small Business Stock
You will need to watch out for the following common pitfalls when trying to qualify for QSBS:
- Converting from LLC to C-corporation: Timing is crucial when converting your business from an LLC to a C-corporation. If done too late, you may disqualify the stock from being treated as QSBS. Also, if you initially elect for your business to be taxed as an S-corporation, then you cannot later qualify for QSBS by converting your business into a C-corporation;
- Redemptions: If a company redeems stock (i.e., buys back shares from its stockholders), it can affect QSBS eligibility for all stockholders. Certain redemption events can disqualify stock from receiving QSBS benefits, so careful planning is essential when redeeming stock; and
- Investor Strategies: Some investors may use strategies like “stacking” (i.e., acquiring QSBS through multiple entities or trusts) to maximize tax exclusions. However, these strategies require careful tax and legal planning to avoid QSBS pitfalls or IRS challenges.
Maximizing Qualified Small Business Stock Benefits: Strategies for Founders and Investors
To fully realize the tax benefits of QSBS, it’s essential to plan and work with experienced legal and tax advisors. Here are a few strategies to consider:
- Proper Structuring from the Start: Founders of QSBS-eligible businesses should ensure that their companies are set up as C-corporations and meet the asset and operational requirements to qualify for QSBS from day one. Investors should invest in C-corporations that meet these requirements.
- Fundraising Considerations: When raising funds through convertible notes, SAFEs, or equity, both founders and investors should ensure that any agreements are structured to help preserve QSBS eligibility.
- Estate Planning Opportunities: QSBS stock can provide tax-efficient estate planning opportunities for founders and investors.
Real-World Examples of QSBS in Action
Here are two simple real-world examples highlighting the potential tax savings available through QSBS.
Example 1: Founder Exits Tech Startup: A founder sells their tech company (a Delaware C-corporation) after holding QSBS for six years. The founder’s basis in the stock (i.e., the amount they invested) is $100. The sale nets the founder $25 million in capital gains. Thanks to QSBS, the founder can exclude $10 million of those gains from federal taxes, representing $10 million of tax savings that otherwise would have been taxed at the federal long-term capital gains rate.
Example 2: Early-Stage Biotech Investor: An early-stage investor holds QSBS for five years in a biotech company (a Delaware C-corporation) that is acquired for $300 million. The investor’s original investment was $2 million. Under QSBS, the investor can exclude up to 10x their original investment (i.e., $20 million), resulting in massive tax savings on the sale of its shares.
Important Caveats
This blog focuses on QSBS tax treatment, generally applicable under U.S. federal income tax rules as of January 2025. These rules may change as new legislation is put in place. Also, some states do not provide a similar tax exclusion for QSBS, so it’s essential to consult with your own legal and tax advisors to determine the availability of QSBS for your shares and any resulting tax impacts.
Conclusion
For founders and investors in tech, biotech and other startups, QSBS represents significant tax-saving opportunities. However, ensuring your stockholders qualify for QSBS treatment requires careful planning in structuring your company as a C-corporation, meeting the necessary holding period and other key requirements.
By understanding the rules and avoiding common pitfalls, you can maximize the financial benefits of QSBS and realize significant tax savings. As always, it’s crucial to consult with legal and tax advisors to tailor your strategy to your specific situation.
Consult with a startup attorney today!
Clients Also Ask Us:
What qualifies as a Qualified Small Business for QSBS?
The company must be engaged in an active business that is not excluded under IRC Section 1202. For example, companies that provide professional services (such as law, finance, or consulting) or are engaged in hospitality or real estate do not qualify. However, companies focused on tech, biotech, life sciences, and climate tech typically meet the criteria.
What is the 80% rule for QSBS?
The 80% rule for QSBS requires that at least 80% of the corporation’s assets be used in the active conduct of a qualified trade or business for substantially all of the stockholder’s five (5) year holding period.
Is QSBS exempt from state tax?
QSBS may or may not be exempt from state taxes, depending on the state. For example, California does not conform to the federal QSBS exclusion, so QSBS gains are taxable at the California state level.
How do I get QSBS for my LLC?
LLCs do not qualify for QSBS, but you may be able to convert your LLC to a C-corporation before issuing QSBS-eligible stock.
