By Dr. Jim Dahle, WCI Founder
Selling your small business can be one of the happiest and most profitable days of your life. However, it often comes with a nasty tax bill. Even with long-term capital gains treatment, you're likely paying 20% of the gains in that business (which is often the entire value of your boot-strapped startup) in capital gains taxes. Add on Net Investment Income Tax (NIIT) of 3.8%, and you're only going to walk away with a little more than 3/4 of the value of the business you worked so hard to build.
Well, Uncle Sam wants people to create and build small businesses, so he has put a tax break into place to encourage that behavior. It is called Qualified Small Business Stock (QSBS) treatment. Here's what you should know.
What Is Qualified Small Business Stock?
QSBS is stock in a C Corporation that was acquired at issuance in exchange for money, property, or services. The corporation can never have had more than $50 million in assets prior to the time of the issuance of stock. The stock must have been held for at least five years. It also cannot operate in any of the following fields:
- Health
- Law
- Engineering
- Accounting
- Actuarial science
- Performing arts
- Consulting
- Athletics
- Financial services
- Brokerage services
- Any trade or business in which the principal asset is the reputation or skill of one or more of its employees
- Banking
- Insurance
- Farming
- Hotels
- Restaurants
More information here:
10 Reasons You Should Own a Business
Tax Preparation Checklist for Small Businesses and the Self-Employed
What Is QSBS Treatment?
If you sell QSBS, you can exclude the greater of $10 million or 10 times your basis in the stock. That could save you $2.38 million in capital gains and NIIT taxes. In fact, it could theoretically save you almost $12 million in taxes.
What's the Downside?
The downside is that it has to be QSBS. This is for founders, not investors. If you buy in at any time after the C Corporation is formed, you don't get this treatment.
If the business is not formed as or converted to a C Corp, your ownership is not QSBS. There are many advantages to sole proprietorships, partnerships, LLCs, and S Corps and many disadvantages to C Corps. You lose all of the advantages of the pass-through entities and deal with all of the disadvantages of a C Corp, and you will do so for at least five years if you want this particular advantage.
If you have not owned the shares for at least five years after it was formed as or converted to a C corp, it is not QSBS.
If the business is involved in any of the above listed fields, it is not QSBS.
When founding businesses, consider founding them as a C Corporation, especially if you expect to sell it after five years for less than $50 million. The tax savings could be significant.
What do you think? Have you received or expect to receive QSBS treatment for your business? Why or why not?
I do not believe the following is true:
“If the business became really successful and was sold for $52 million, it is not QSBS.”
The $50 million test is at the time of issuance. Not when the company is sold.
Thanks for the correction.
I scrolled down looking for the rest of the the article….
Seems like this article ended abruptly and pretty much contained just bullet points.
It’s a shorter post than most at 611 words, but it ends the way most do with a question and invitation to comment, not the list of bullet points. Maybe refresh your browser?
I was just hoping for more…
Just a little disappointed and spoiled by the detailed content I’ve read here over the years.
Sorry. Couldn’t think of anything else to say on the subject.
We founded a startup as a Delaware C-corporation, and were granted stock at the founding of the company. Our plan is to use this IRS Section 1202 QSBS as a way to save on federal taxes if the company ever goes big. My understanding is that this QSBS exclusion amount applies to every founder. It’s not one amount excluded for the whole corporation.
We also live in a high-income-tax state, and my CPA thinks the state would follow the federal exclusion of QSBS. But I’m not so sure.
I think you may be right, although I’m not sure spouses get two amounts.
Thanks for the article. QSBS exemption is a good opportunity for entrepreneurs and founders to be exempt from federal capital gain taxes. Some states (such as MA where I live) also have QSBS exemption.
Founders should know this does not apply to income taxes due at the time stocks vest. You can file an 83b election to pay income tax on the value of the stock at issuance. Must be filed within 30 days of issuance. Lots of factors to decide if that’s the right choice.
I just want to point out that you CAN invest in QSBS/1202 companies (this is NOT just for founders). There are private equity/growth equity firms that specialize in this (even as late as Series C/D funding) and will even assist in reinvesting your capital+gains, when the first company gets sold, into a second (or multiple) 1202 qualifying company(ies) to get your investment to the five year minimum to maintain the cap gain exclusion.
Interesting. Thanks for sharing.
meb faber has talked about this for forever on his podcast as one of the biggest tax loopholes if you want to do some more digging. i believe this is why he has a lot of angel investments, specifically to capitalize on the tax benefit.