How to Leave Money on the Table: Ignore QSBS

Mike Lodzinski
Published on

Congratulations! You just sold the company you founded 8years ago, and your equity in the sale is worth $10 million.

Quick question – would you rather pay $2.4 million or $0 in taxes?

If you made plans around the QSBS exemption, it’s likely you’ll owe a blissful $0 in federal capital gains taxes. If you were unaware of this powerful tax provision, well… Let’s just say Uncle Sam will be grateful for the $2.4 million you now owe him.

You may be wondering how on earth this is possible. Toexplain, let’s take a step back. What is QSBS, when does it apply, and how can benefit?  

What is QSBS?

Qualified Small Business Stock (QSBS) refers to stock in a Qualified Small Business (QSB), as defined by the Internal Revenue Code (IRC) Section1202. In simple terms, a QSB generally meets the following qualifications:

·      The company must be structured as a U.S.C-Corporation.

·      The company must hold less than or equal to $50million in assets when the stock is issued.

·      The company must take part in a qualifying business type.  

Excluded business types include professional services such as consulting, financial services, hospitality, law, etc. Many technology companies and startups qualify if they meet the above conditions.

When Does QSBS Apply?

There are a few additional qualifications that a taxpayer must meet to secure the QSBS tax benefit:

·      Stock must be held for 5 years. This is acritical point to understand. Unexercised stock options, for example, do not qualify.

·      The shareholder must buy shares from the company directly (i.e. cannot repurchase shares through a secondary transaction).

·      The shareholder must not be a corporation.

·      The shares must be issued in exchange for property, cash, or other services.

The good news for investors is that once securities have been purchased at a QSB eligible point in time, the stock maintains its tax-beneficial status and does not lose its QSBS certification. This does not change if the company ceases to meet the requirements for a QSB, if the company is acquired, or if the stock is transferred to another owner.

Additionally, some gains from the sale of QSBS owned for at least 6 months can in certain cases still be deferred through what is called a rollover transaction. To accomplish this, the owner must reinvest the proceeds from the sale into another company’s QSBS. For example, this means that an investor in the QSBS of a high-growth startup that exits within 3 years (less than the required 5 year holding period) can invest the proceeds into another QSB within 60 days and elect gain deferral (under IRC Section 1045). This option can benefit the investor by reducing their cost basis (and associated gain from the rollover) for the new QSBS.

It is also possible to own both qualifying and non-qualifying stock in a company. For example, say an investor purchases stock in a company at a time when the firm holds <$50 million in assets and is classified as a QSB. Several years later, the company holds >$50 million in assets, and the investor elects to purchase additional stock. In this case, only the investor’s original investment would be classified as QSBS and be eligible for the preferential tax benefit.

What is the Benefit of QSBS?

QSBS is a big deal. Why? Because a seller of QSBS that has been held for at least 5 years can exclude 100% of federal capital gains tax. The exclusion can be for up to $10 million or 10x the original investment, whichever is greater. Tax rates on long-term capital gains vary, but generally include up to a 20% federal, 3.8% Obamacare, and 13.4% state tax depending on the location of the business and status of the taxpayer.

QSBS represents a massive potential tax benefit for founders, investors, funds, employees, and more. At its core, the benefit increases the upside for an investment (of time or capital) into an innovative small business. This encourages entrepreneurship and growth, and (as the opening example illustrates) can result in lucrative exits.

Practical Tips for Maximizing Value from QSBS

The first step to successfully leveraging the powerful benefits offered by the QSBS benefit is awareness. Congratulations! If you’ve read this far, you’re more informed than many.

Here are 3 more practical tips for maximizing value from the QSBS tax benefit:

1.      Plan Ahead: When it comes to QSBS, timing matters. Consider the potential benefits of QSBS savings when entering or exiting investments. Spending the extra time to plan can be well worth it.

2.      Keep Detailed Records: To claim the benefit, detailed records are crucial. Be sure to record and safely store details about the purchase, sale, and holding period of the stock. This information must be submitted when filing taxes for the year in which the QSBS is sold, so save yourself the headache by staying organized ahead of time.

3.      Involve Professional Counsel: There are a variety of nuances applicable to each unique situation, so it is vital to involve professional counsel as early as possible in any investment decision. This will minimize any unintended mistakes and guarantee the most tax-efficient strategy.

Final Thoughts

As seen in our opening example, the QSBS tax benefit can provide small business owners and early-stage investors with a valuable tax break on their investments in small businesses. By understanding the fundamentals about QSBS and by following these practical tips, you can help support the growth and success of small businesses while simultaneously maximizing personal returns. If you’re still not sure whether this benefit applies to you, our team can help. Don’t miss out on the possibility of substantial tax savings; contact our experts today.

About the Author
Mike Lodzinski

Mike started his legal career in 2005 as an Associate in theCorporate & Securities Practice Group of Thompson & Knight LLP. Afterleaving Thompson & Knight, Mike worked in various in-house roles ofincreasing responsibility with Toshiba, Hewlett-Packard Enterprise and Hempelexpanding his experience in a variety of industries, including renewableenergy, oil and gas, manufacturing, and power generation, among others. Mike iscurrently General Counsel of Advario North America, a leading provider ofstorage and logistics solutions in the energy and chemical industry.

In 2009, Mike founded Nighthawk Machinery, a manufacturer and distributor of solid tires and rubber tracks for the construction industry, which was acquired by a competitor in 2018. Since 2018, Mike has invested in several start-ups and early-stage companies and has been active as an advisor in various legal and non-legal capacities. In addition to his role with Advario, Mike is a Partner at Pursuit Legal, a boutique business law firm that provides intelligent legal solutions to SMEs and startups, where he uses his unique skill set to advise a select handful of start-ups and early-stage companies from the idea stage through scale-up.

Mike is a graduate of Texas A&M University and Duke University School of Law.

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