As a founder, investor, or early employee at a startup or small business, qualified small business stock is perhaps the best tax break you never heard of. When criteria is met, qualified small business stock (also called QSBS or referred to as IRC Code Section 1202) enables individuals to sell their shares tax free. Yet even with qualifying stock, hurdles remain. First, taxpayers may not know about QSBS! And second, mergers and acquisitions can threaten shareholders’ ability to sell shares tax-free. Here are tips and strategies from a financial and tax advisor on ways to maximize the benefits of qualified small business stock.
This article provides information for informational purposes only and should not be misinterpreted as personalized advice of any kind or used as the basis for making any type of tax, financial, legal, or investment decision.
What Is QSBS Stock?
There are several requirements for shares to be eligible for Section 1202. Typically, qualifying hinges on these key factors:
- When shares are acquired, the company’s aggregate gross assets must be less than or equal to $50 million
- Stock must be acquired directly from a U.S. C Corporation at original issuance
- Minimum five year holding period
- Exercises of stock options, shares of founders stock, preferred and restricted stock can all qualify under Section 1202
- Certain businesses, like professional services, do not qualify
This article has more on the QSBS stock qualification rules. But again, note: even if you currently have QSBS-eligible (or future eligible) shares, certain activities, such as acquisitions or share buybacks, could jeopardize your ability to claim tax-free tax treatment.
Capital Gains Exclusion Under Section 1202
Qualifying sales offer an annual gain exclusion equaling the greater of:
- $10 million lifetime cap per taxpayer, less prior sales of QSBS from the same company
- Ten times basis in the company
Additional benefit: the QSBS rules and limits apply on a per-issuer basis. In other words, serial entrepreneurs and taxpayers engaging in proactive wealth planning strategies may be able to maximize their savings well beyond $10 million.
Knowledge Gap And Common Mistakes
Being able to exclude 100% of the gain from sales of startup stock is an immense tax benefit. But unfortunately, employees may miss out if they don’t have the right professional team in place or resources at work. As a wealth advisor specializing in stock options, I’ve seen firsthand how crucial an experienced, collaborative team is for positive client outcomes.
One key collaborator is Jeff Krueger, CPA, a tax advisor with Seaport Financial Partners in Boston, MA, who also supports founders and employees with equity compensation. He says a key success factor is how well a company educates employees on qualified small business stock and potential employee eligibility. However, even if the company does provide valuable education and general resources, shareholders should strongly consider engaging their own team of experienced financial, legal, and tax advisors for personal advice.
On the individual side, we both agree one of the biggest mistakes people make with QSBS is not exercising stock options early enough. Krueger says founders also set up the company wrong (e.g. not as a C Corporation), but that can be fixed if the mistake is caught early enough.
Strategies To Maximize Tax-Free Sales of Qualified Small Business Stock
Finding out you may eventually have QSBS is just the first step. A lot needs to go right between a shareholder’s initial eligibility and a resulting (qualifying) stock sale. It’s like the early Super Mario Bros. video games. In any level, you could collect extra coins or escape danger with power-ups, but make the wrong move and it’s game over. Thankfully, like the video game, nothing in section 1202 will actually harm you in real life. But there are things that can kill your eligibility to sell stock tax-free.
Acquisitions Of Early-Stage Startups
The vast majority of successful startups will exit via acquisition versus a traditional IPO. But what happens if you haven’t met the five-year holding period yet or the deal includes stock of the buyer? Depending on the terms of the deal and goals of major shareholders, there may be some unique planning opportunities. There are many other factors to consider and ways to structure a sale, but here are two ways new founders could extend their 1202 runway during an acquisition.
Section 1045, QSBS Rollover And Reinvestment
Sometimes, a deal is too good to pass up. But what happens if you haven’t held the QSBS shares for at least five years? Krueger says a tax-free rollover into replacement QSBS under Section 1045 may be an option to consider. He says serial entrepreneurs often use QSBS rollovers to defer taxes and extend the holding period to reach the five-year requirement.
At a high level, under Section 1045, investors can tack their original QSBS holding period onto replacement stock by reinvesting in a company that currently meets the criteria for qualified small business stock within 60 days.
Although finding replacement QSBS can be challenging, this route can also provide greater flexibility for shareholders in determining how much to defer and in which investment. Deferred gains reduce cost basis in the replacement QSBS. If the rollover stock is later sold meeting the requirements of Section 1202, it may be fully tax-free subject to the limits. Otherwise, the taxpayer would pay tax at capital gains tax rates or could consider another 1045 QSBS reinvestment.
Exchange Of Qualified Small Business Stock
Another way to tack onto the holding period of original QSBS is through a Section 351 exchange or Section 368 reorganization. These options also have the potential to retain the tax benefits of Section 1202 and provide for tax-deferral (full or partial) when the buyout is complete. Krueger says these moves must be considered by the deal team, which includes the corporate lawyers and accountants. It’s not uncommon for company acquisitions to require a certain amount of rollover equity, particularly for founders and key shareholders.
But essentially, when done properly and all the facts align, these avenues have the potential to preserve the whole gain exclusion under Section 1202 if the buyer’s stock is QSBS. If it isn’t, the exclusion can still apply when shares are ultimately sold, but only on the gain that was deferred at the time of exchange.
Caution Against Over-Optimizing
M&A transactions are very complex and require the support of corporate and personal advisors. As you discuss your options with your team, don’t lose sight of the bird in hand. Krueger recalls a client missing tax-free QSBS treatment by only six months due to the timing of an acquisition. Yet even in hindsight, the client likely made the right decision. He notes that planning can cut both ways — had the client delayed six months, they would have been dealing with tariffs, and perhaps the deal would have fallen through altogether.
Similar issues can arise with tax-free QSBS rollovers and exchanges. Businesses fail every day. Repealing the rules for qualified small business stock has been a longstanding topic in Congress. The timeline to liquidity is unknown and there are still a number of ways for a gain exclusion to be invalidated along the way.
As with most things in personal finance and investing, the key is making an informed decision and prioritizing when you can control.
Trusts And Gifting
Another advanced planning technique to maximize the tax-free sales of qualified small business stock can be by gifting QSBS outright to children or family, or more commonly, using trusts for additional control, creditor protection, and other benefits. As stated earlier, the limit on qualifying sales of Section 1202 stock is generally capped at $10 million per taxpayer. So with this strategy, shares of QSBS can be put into trusts for different taxpayer beneficiaries.
Krueger recently had a client set up three different trusts, for their children and a parent, which are projected to extract $40 million in tax-free value after considering the client’s ownership. However, despite the tax benefits, this approach requires careful planning and support from a trust and estate attorney.
For example, the trusts need to be set up strategically and correctly. The original founder/shareholder must also ensure they can support their lifestyle and income needs if they effectively give away these assets for the benefit of others. Gifting and trust stacking can also become much more difficult after the company has met success, given the lifetime gifting limits.
State Tax Considerations
Thankfully, most state tax laws conform to the federal QSBS rules. But, there are notable exceptions, such as California. Krueger says to discuss your situation with your tax advisor because if you’re willing to relocate, moving to a QSBS-friendly state before selling can be beneficial. Generally, he says even if stock options were exercised in a non-conforming state, state income taxes are typically assessed only by the taxpayer’s current state of residence upon sale, provided the one-year-and-one-day investment income holding period is met.
Documenting Sales
Cementing the massive tax benefits of qualified small business stock may ultimately come down to the very pedestrian issue of paperwork and the multiyear retention of those documents. It is up to the stockholder to maintain documentation to substantiate their eligibility for QSBS in the event of an IRS audit. At the very least, Krueger suggests getting records of:
- Stock certificates, purchase agreements, and 83(b) elections
- Balance sheets pre and post-issuance (or ideally, reviewed/audited financial statements)
- Copy of the capitalization table over time to confirm no redemptions
- Articles of incorporation/By-laws
Ideally, he says a company will get an opinion letter after reaching the $50 million asset threshold, perhaps from a Big 4 accounting firm, and distribute that to employees at some point. Additional recordkeeping items that can be helpful include a QSBS eligibility checklist (signed by CFO) or the corporate tax returns aligning with stock purchases.
Maximizing QSBS Tax Benefits For Founders and Employees
As with anything in the tax code, qualified small business stock is complicated, particularly when considering ways to get the most out of tax-free sales. The most lucrative planning strategies are typically the ones done early. So if you have QSBS, or think you might, don’t delay taking steps to get your professional team together. For founders and business owners, proactive employee communications and education can help deepen loyalty, align incentives, and even streamline efforts for leadership though consolidated messaging and outside resources. For example, consider hosting an educational session for employees led by an independent wealth advisor and Certified Public Accountant.
Wherever you are in your QSBS journey, make sure you have the right team in place and fully understand options in planning and when navigating change. After all, $10 million tax benefits don’t come around too often.
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