EquityZen's Blog On Startups and Their Economics

Major Tax Break for Startup Founders, Employees, and Investors Made Permanent

Nat Disston | February 11, 2016

A lot of great legislation has been pushed forward over the years in startup-landia. Some recently include the JOBS Act, Reg A+, and Congress' decision to widen the net on the definition of an accredited investor. All of these help to increase capital formation, promote long term investing and building new businesses. Most recently this year, buried in the nearly 900 page Protecting Americans from Tax Hikes Act, a new feature was made permanent in the Tax Code that has a deep impact on entrepreneurs, shareholders, and investors of private companies. It's Section 1202 of the Tax Code and deals with  Qualified Small Business Stock (QSBS), and it could give you a 100% tax break on an specific investment. So, what do you need to know about QSBS?

What is QSBS?

It is section 1202 of the Tax Code and was originally introduced in the early '90's to promote investment in small businesses. The code allows for capital gains tax exclusion on certain stock held for more than 5 years. This code was set to expire, has been extended numerous times, and was permanently added to the Tax Code at the beginning of this year. Specifically, it allows shareholders (founders, employees, and investors) of small or new businesses to exclude a certain amount of their investment from taxes. These shareholders who put money into a qualifying corporation can enjoy up to a 100% tax break on that investment gain with no offset to the AMT tax (more on the AMT here).

What Qualifies for QSBS?

A qualifying corporation must be, more specifically, a domestic C corporation (no S Corp or LLC), which you can read more about here). Additionally, they cannot be services based firms (think law firms and financial services). The company must also have less than $50M in total gross assets at the time of stock issuance (read: post-money if you're an investor). There are thousands of startups that receive funding each year and it's not difficult to imagine that many many more companies remain under the $50M in assets threshold for some time. In 2014, over 1.5 million companies filed tax returns below that threshold. In the startup world, that probably covers most companies that are Series B and earlier. Finally, the stock must be held for at least 5 years which makes the standard 2-year capital gains threshold feel like a New York minute.

What Can I Save Under QSBS?

Anyone who holds QSBS for the requisite period can benefit from its substantial tax breaks. All principal players in the startup community--founders, employees, and investors--can benefit from QSBS. How much do they benefit? The amount that can be excluded from taxation is the greater of 10x your investment or $10MM. Shielding up to $10M from taxes can result in millions of dollars of tax savings. To confirm, any investment gain on QSBS stock up to $10,000,000 worth can be 100% excluded from capital gains tax treatment. However, 5 years sounds like a long time to hold one stock, so if the investment is sold within that time it can be re-invested into a new QSBS within 60 days to defer the taxes.

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Unfortunately, the QSBS tax break goes largely unnoticed by many. However, it can have a huge savings impact for all shareholders involved in a young company - the founders, investors, and employees. If you were ever issued stock in a start-up (seed stage, many Series A, and even some Series B companies would qualify) you should consult your accountant or financial advisor about taking advantage of section 1202 for your Qualified Small Business Stock.

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