Benjamin Franklin suggested that death and taxes were life’s only certainties. But perhaps his advisors didn’t know enough about the Qualified Small Business Stock (QSBS) exemption. So if you are facing a potential taxable event from shares you acquired in a private company, understanding the ins and outs of Section 1202 of the Internal Revenue Code (IRC) just might ease the pain of one of life’s inevitabilities.
Section 1202 of the IRC is commonly referred to as the QSBS exemption. If you are a founder, angel investor, or an employee of a successful early stage company, you need to be aware of certain qualifications that could help you protect up to $10 million (or 10 times your cost basis, whichever is greater) from federal taxes.
The Basic Requirements
You must meet several key requirements to benefit from the QSBS exemption. Particularly, you must have held your stock in a Qualified Small Business for at least five years. For purposes of this part of the tax code, a Qualified Small Business is defined as:
- A domestic C Corporation
- An entity with cash and other assets totaling $50 million or less, on an adjusted basis
- Any business other than: (a) services firms such as health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial or brokerage services, (b) banking, insurance, financing and similar businesses, (c) farming, (d) mining and other natural resource businesses (e) operation of hotel, motel, restaurant or similar business.
- An entity that is actively running a business. In other words, at least 80% of the assets of the firm must be used to actively run the business, not for investment purposes.
The other key requirement is to understand when and how you acquired the stock. This requirement has been in place since 1993, but it has since undergone a few improvements. The table below lays out the actual savings based on the date you acquired shares:
Date Acquired | Exclusion % |
Effective Regular Tax
& Net Investment Income Tax Rate
|
Effective AMT
& Net Investment Income Tax Rate
|
On or before Feb. 17, 2009 | 50% | 15.90% | 16.88% |
Feb. 18, 2009 to Sept. 27, 2010 | 75% | 7.90% | 9.42% |
Sept. 28, 2010 or later | 100% | 0% | 0% |
A Real World Example
Let’s say Mr. Jones started ABC Company on January 15, 2009, using $10,000 in cash. In October of 2010, Ms. Doe, an early employee received 200,000 options exercisable at $0.05/share which she immediately exercised. In July of 2012 Mr. Lee made an investment of $500,000 when the value of the firm was $5,000,000.
The Finer Points
Certain redemptions can potentially disqualify some purchases of stock from QSBS treatment. Specifically, redemptions in excess of 5% of the aggregate value of the corporation’s outstanding stock within one year (either before or after) of the purchase of stock will disqualify it from QSBS treatment. Redemptions from a “related person” of the holder within two years (either before or after) will also disqualify stock from QSBS treatment. Generally, redemptions from departing employees do not disqualify purchases from QSBS treatment.
Some Common Questions
- What happens when you own QSBS that is acquired for stock that is not QSBS? In this case, the stock retains its treatment, but the gain eligible to be exempted under Section 1202 is capped at the time of the exchange. All stock received via gift, death or distribution also retains its QSBS treatment and the holding period of the original owner is tacked on to the subsequent owner.
- What if you are a founder whose company is currently an LLC? If the asset requirement can be met, you may consider converting from an LLC to a C Corp (but make sure you get expert tax advice to make this a qualified transaction). Your holding period then begins at the time your shares are acquired from the C Corp.
- What if you are using a SAFE or Convertible Note instrument? Importantly, the holding period and asset requirement does not begin until conversion is completed. This could leave you susceptible to receiving stock that is not QSBS eligible.