- An often overlooked tax perk can supersize your startup’s exit payout by wiping out capital gains taxes on at least $10 million in profits — or on a whopping ten times the amount of your original investment — whichever is bigger.
- The tax exemption is for Qualified Small Business Stock, or QSBS.
- “Investors have missed this hidden gem time and time again,” a tax partner at law firm Cooley LLP told Business Insider. “Now everybody is saying, ‘Oh my god.'”
- There are four criteria your startup needs to meet to qualify for QSBS, and a lot of pitfalls. Here’s your checklist for nailing it.
Some of the first investors in stationary-bike startup Peloton are on track to score a nice, oversized payout. But not just because they got into a would-be unicorn early.
The reason: An obscure tax loophole that all founders and investors in young companies can take advantage of — if they plan well and know how it works.
Called Qualified Small Business Stock, or QSBS, the tax break allows early startup shareholders who meet specific requirements to avoid paying long-term capital gains taxes when they sell their shares. They can apply the QSBS tax advantage on at least $10 million in profits or up to 10 times their original investment, whichever is larger.
The federal tax rate for long-term capital gains is currently 20% (plus 3.8% for Obamacare). Under QSBS, that 23.8% stays in your pocket, rather than going to the government.
If the company operates in a state that also abides by QSBS, shareholders can avoid paying state taxes on their windfalls as well.
This is the case for Peloton, which was founded in New York. In an amended investor’s rights agreement from February 14, 2019, Peloton said it expected shareholders of its preferred stock to benefit from QSBS.
“Investors have missed this hidden gem time and time again,” Alexander Lee, a tax partner at law firm Cooley LLP in Santa Monica, Calif., told Business Insider. “Now everybody is saying, ‘Oh my god.'”
The millions you can save from QSBS can mean the difference between retiring early or continuing the daily grind
Let’s give a couple examples of QSBS in action.
Say you founded a company, owned 50% of the shares by the time you exited, and sold your startup for $10 million. You likely paid very little for those shares — say, $500 — and never owe capital gains taxes when you recoup your original investment.
Instead of having to pay 23.8% to the federal government for long-term capital gains on your nearly $5 million return (or close to $1.2 million, leaving you with just under $3.8 million), you’d get to keep all of it, minus the state tax owed if your company is based in a handful of states that don’t recognize the benefit, like California. If, like Peloton, your company is based in a state that recognizes QSBS, you’d get to keep all $5 million.
Now, say you were an early angel investor who put $10 million into a startup. If the company’s valuation grew tremendously and the company went public or was sold for hundreds of millions or billions, your potential tax-free haul under QSBS would be $100 million, or up to 10 times the amount you invested in the first place.
Without QSBS in that second scenario, you’d owe nearly $24 million to the government on the $90 million return from your $10 million investment.
Another clever thing you can do with QSBS is use it to get your family rich. With some creative planning, you can gift your qualifying stock to heirs through certain trusts, and set each one up for the $10 million or 10-times your investment benefit of tax-free returns.
QSBS “sounds almost too good to be true,” says Michael Shaff, a lawyer who is chair of the tax and estate planning practice at Stubbs Alderton & Markiles in Sherman Oaks, California. “But it is.”
There are 4 basic criteria you need to meet to qualify for the QSBS tax break, and you need to plan for it early in your startup’s life cycle.
Not every small business qualifies for QSBS. The company needs to be set up in a very specific way to reap the tax benefits:
- You need to receive shares in the company when it is still small — when that company has gross assets of $50 million or less. If you get shares of a company like Airbnb right now, for example, it’s too late to qualify for QSBS. Your startup also has to use at least 80% of its assets to conduct its business. So no hoarding cash that doesn’t actually contribute to the company’s operations.2).
- The company has to be set up as a C corporation. If your company is set up as a partnership, limited liability company or another so-called “passthrough” that, unlike a C corporation, doesn’t pay taxes at the entity level, no dice.
- Your startup has to actually create or manufacture stuff, like new forms of technology or widgets. And it has to be in a field that qualifies for the benefit. Service firms in law, finance, architecture, accounting, and health care (i.e. doctors’ offices) don’t qualify. Neither do real-estate investment trusts, sales companies, restaurants, hotels or oil and gas extractors. Cooley’s Lee said that while the benefit is mainly for technology companies, he has a lot of brick-and mortar manufacturing companies in the Midwest that qualify for QSBS too.
- You generally have to hold onto your stock for at least five years before selling it. There are a couple ways around this qualifier, though (more on that below). But if you’re granted stock options, and not actual shares, your payout horizon is much longer — the 5-year holding period starts the day you exercise them, not the day they’re granted. Which means QSBS typically has the most bang for the buck when you’re a founder, angel investor or board member, since those are the people that typically get actual stock in a seed company.
There are a lot of ways founders and investors can mess up QSBS. Here are some of the most common pitfalls:
Eric Bahn, a serial entrepreneur based in Silicon Valley, learned about QSBS the hard way. He didn’t set his up his GMAT-focused startup as a C Corp, and he wound up paying $1 million in federal taxes when it exited in 2012.
“I lost so much money from this stupid startup decision,” Bahn lamented in a Reddit post in 2014.
Today, he tells Business Insider that “it was a real bummer — even a lot of business-oriented accountants are unaware of this rule.”
Creating the wrong kind of company is just one common QSBS pitfall. Others include:
- Screwing up the $50 million in gross assets limit by having too much real estate or cash on hand.
- Not acquiring QSBS stock when it was originally issued. No trying to sneak in later by buying an existing shareholder’s cache.
- Selling your startup in an asset-only deal. You lose the tax benefit if your startup sells its assets but keep its QSBS stock. So make sure your shares are being purchased by the acquirer, not just assets like your websites or trademarks.
For other common pitfalls, check out law firm Frost Brown Todd’s checklist.
Private equity, venture capital and other investment funds can’t take the benefit on their own shares, but they can invest in startups that do. And while investors in such funds can get the tax benefit, they have to be in the fund at the time the qualifying shares are issued.
Already started your company and screwed up QSBS? It might not be too late to fix it.
No need to panic if you botched things and formed your would-be unicorn as a limited liability company. You can easily convert later to a C corporation. Still, the 5-year holding clock starts when you make that change, not when you originally issued and acquired the shares.
Even then, there are creative ways to tinker with the 5-year holding period — useful if you think your startup is on the road to Failville or if you sell your company before five years and don’t want to take the capital gains hit.
If you hold your qualifying stock for at least six months, sell it, then roll over the gain into a different startup whose own stock qualifies for QSBS treatment, you’re good to go, with the holding period continuing from the date you acquired stock in the first company.
“It’s like a lateral in football,” Shaff said, adding that it’s particularly useful for startups that hit it big and get sold in under 5 years.
Very simple decisions can lead to millions of dollars
A softened version of the QSBS incentive has been around for nearly three decades and gained steam during the 2008 financial crisis. By Sept. 27, 2010, qualifying stock issued after that date got a 100% free ride from capital gains taxes. But nobody paid attention until President Donald Trump’s 2017 tax law slashed the corporate rate to 21% from 35%.
That’s because before the landmark cut, the benefit was often more trouble than it was worth — startup founders shied away from the C-corp status required to get it, because who wants to pay 35% on a company’s profits?
But with the lower corporate rate, “QSBS is nuts,” Bahn, the startup founder who missed out on $1 million, says. Bahn has gone on to co-start a fund that now takes full advantage of QSBS.
His advice to other founders: pay attention, while QSBS lasts. While Democratic presidential contenders Elizabeth Warren, Joe Biden and Bernie Sanders haven’t specifically mentioned the perk, they’re all embracing tax-the-rich proposals, which is essentially what QSBS helps avoid.
“The very simple decisions you can make now,” Bahn said, “can lead to millions of dollars of savings later on.”
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