Startup founders and investors could miss out on huge tax savings if they fail to consider the potentially significant tax benefits of holding qualified small business stock (QSBS).
Why it Matters
Stockholders may potentially exclude from income all or a portion of any gain recognized on the sale of QSBS held for more than five years. This may mean no federal tax. (Note that some states, including California, have not adopted the QSBS rules, so state taxes could still apply.)
How Big Is the Benefit?
How much gain can be excluded from the sale of QSBS depends on when the stock was acquired and whether the gain exceeds the applicable limitation. In general, stock acquired after September 27, 2010, is eligible for a 100% exclusion. For stock acquired earlier, only a partial exclusion is available.
The gain on sale of QSBS that is eligible for the exclusion is the greater of $10 million per taxpayer, per issuing corporation, or 10x the taxpayer's basis in the stock. (Usually, the basis is the cost of the stock). The limit is applied on a per-partner or per-stockholder basis if the QSBS is held through a partnership, LLC, or S corporation.
For example, an investment fund acquiring QSBS for $20 million may exclude up to the greater of $200 million or $10 million for each of its partners or stockholders (e.g., fund limited partners).
Taxpayer Requirements
The taxpayer must be a noncorporate taxpayer that sells QSBS that it has held for more than five years.
If QSBS is sold without being held for five years, it may be eligible for a different benefit (commonly called a "rollover") if it has been held for more than six months. For this rule to apply, the taxpayer must acquire other QSBS within 60 days of the sale. There is no limit on the amount that can be reinvested other than the fact that the new stock must constitute QSBS (and thus the reinvestment can never exceed $50 million, as discussed below).
Corporate Requirements
To constitute QSBS, the following requirements (among others) must be satisfied:
- The issuing corporation is a U.S. C corporation.
- The instrument that is acquired must be stock (or treated as stock) acquired from the issuing C corporation in exchange for cash, property, or services. Although the proper tax treatment of SAFEs is not entirely clear, most SAFEs state that they are intended to constitute "stock" for purposes of the QSBS rules.
- The issuing corporation's assets from its inception until immediately after the stock issuance are $50 million or less. In most cases, this test is based on the tax basis of the corporation's assets.
- The corporation uses at least 80% of its assets (measured by value) in the active conduct of a qualifying business. In general, all businesses qualify other than certain specific types (for example, certain service businesses, banks and other financial businesses, and businesses involving farming, extraction, or hospitality). This test must be satisfied over substantially all of the taxpayer's holding period for the QSBS.
- No redemptions: Newly issued stock is not eligible to be QSBS if the C corporation has made certain types of stock redemptions prior to or following the issuance of the QSBS.
Startup Considerations
Entity choice is a key consideration for startups. A C corporation may be a great choice for many startups and, as noted above, the benefits of QSBS are generally only available for stock of a C corporation. However, it may be possible for a startup formed as an LLC to later convert to a C corporation and still obtain the benefits of QSBS, but careful planning is required.
Because of the $50 million asset cap, if QSBS is important to investors (which it often is), a startup may want to limit the size of a stock offering if it would cause the corporation to exceed the $50 million cap.
If you are interested in learning more about this topic, we would be happy to chat with you. Please contact a Perkins Coie team member to discuss further.
