This article is for informational purposes only and must not be construed as tax advice. Please consult your tax advisor before making any investments. Tax planning is a vital part of any investment strategy. Qualified Small Business Stock (QSBS) provides a potential opportunity to pay no tax on your profit when investing in qualifying companies.
The QSBS exemption was created with the intention of helping companies attract investors with the large tax incentives on offer, plus to attract and retain key staff with employee stock options. The benefits to investors can be very significant, with potentially little or no tax being payable on profits.
Qualified Small Business Stock (QSBS)
QSBS is an important initiative of the US Government to promote investment in US small businesses by providing attractive tax benefits for investors.
What is Qualified Small Business Stock?
Covered by the US Internal Revenue Service under Section 1202 of the Tax Code and supported by the US Small Business Administration, QSBS can be a significant contributor to the US economy by stimulating the growth of small business.
QSBS Tax Exemption – Tax treatment for shareholders
If you purchase Qualified Small Business Stock and the value increases, it may be possible to pay no tax on your earnings. The QSBS tax exemption rules are detailed in Section 1202 of the Tax Code, which can be found here. The US Small Business Administration provides a handy summary of the tax exemption treatment in their article Qualified Small Business Stock: What Is It and How to Use It. The tax benefit to an investor depends on a number of rules and conditions (refer below for the basic requirements) but the key takeaway is that you could earn up to $10 million or 10 times the adjusted tax basis* of the investment (whichever is greater) without potentially paying any tax. * Note the tax basis is equivalent to the cash paid plus the fair market value of any valid non-cash contribution for the stock purchase
Why is it Important?
QSBS is important for investors because it provides them with the opportunity to lower their tax payments on profitable investments. QSBS is important for companies seeking funding because it has the potential to make investment in their company more attractive to investors because of the potential tax breaks available. QSBS is important for the US economy, because according to the US Small Business Administration in their report Small Business GDP 1998-2014 published in December 2018, “Small businesses are the lifeblood of the U.S. economy”, creating two-thirds of net new jobs, contributing 44% of US economic activity, and driving innovation and competitiveness.
Basic QSBS Requirements for Companies
The following summarizes the important requirements of the QSBS tax exemption for companies:
- The company must be a “Domestic C-Corporation”, which means the entity pays its own income tax on corporate earnings.
- Holding companies are not eligible – the corporation must be actively engaged in business operations.
- The company’s assets must not exceed $50 million at all times before or after the issuance of the stock.
- Only certain industries are permitted to qualify, such as manufacturing, wholesale, retail, or technology.
- The company must not be engaged in prohibited industries such as personal services (where the principal asset of such trade or business is the reputation or skill of one or more of its employees), banking, insurance, financing, leasing, investing, farming, or hospitality.
- The company must issue the stock directly to the investor in exchange for cash, services, or property.
Basic QSBS Requirements for Investors
For investors, the key requirements of the QSBS tax exemption vary depending on when the stock was purchased and how long it has been held. For qualifying stock acquired after September 27, 2010, the following summarizes the requirements to be eligible for the tax exemption and the potential outcomes:
- An investor cannot invest as a C-corporation – they must invest as an individual, a trust, or qualifying pass-through entity (a pass-through entity means the entity itself pays no tax and passes the tax liability through to the beneficiary of the entity).
- The tax treatment for investors utilizing a Special Purpose Vehicle (SPV) depends on the structure of the entity, so make sure you get detailed tax advice from your tax advisor, if this applies to you.
- Stock must be held for more than five years to qualify for the full tax exemption.
- For stocks held for more than one year but less than five years, long-term capital gains tax is payable on the profits.
- Profits are subject to a cap on the maximum allowable gain, being the greater of $10 million, or 10 times the original investment amount.
- If the stock is held for less than five years (but more than six months), the investor may be able to execute a tax-free rollover by reinvesting their entire proceeds into another QSBS within 60 days of selling the original stock.
- Investments via a self-directed IRA do not qualify for the QSBS exemptions.
Refer to the notes above for where to find more detailed information about the tax treatment for investors. Note that special rules apply for stock acquired before September 27, 2010, so if that applies to you, make sure you do your homework and consult your tax advisor.
Propel(x) SPVs qualify
If you have invested through one of the Propel(x) SPVs, unless you invested via a self-directed IRA, you will most likely qualify for the QSBS exemptions. However, taxes are a complex topic and tax treatments vary by circumstances. Therefore you should take the advice of your accountant or tax advisor before making any investments. (Propel(x) does not provide tax advice.)
Strategies for using QSBS
With the potential to generate big returns that may require investors to pay little or no tax, companies can utilize QSBS strategically to attract investors and raise capital, or to attract and retain key staff by taking advantage of the tax ruling that allows QSBS to be issued in exchange for services. Strategic investors have the potential to utilize the QSBS tax exemption to reduce their tax on qualifying stock that they hold for more than five years, or if held for less than five years then to rollover their profits into other qualifying investments.
Example of QSBS
To illustrate the potential of investing in QSBS, a couple of hypothetical examples are provided below. To keep things simple, we will assume there were no more funding rounds after an initial investment, so that we do not have to consider stock dilution (you can learn more about dilution in this article). Say a startup raises capital, and an investor purchases 10% of the company for an investment of $1m, implying a post-money valuation of $10M. Six years later, this hypothetical company goes public at a valuation of $60m. The investor’s stock is now worth $6m, representing a capital gain of $5m. Since the investor held the stock for more than five years, and their profit is less than $10m and less than 10x their investment, they get to potentially keep their entire $5m profit without paying any tax. Let’s say another startup raises capital and an investor purchases 25% of the company for an investment of $2m, implying a post-money valuation of $8M. Seven years later, this hypothetical company is acquired by a competitor at a valuation of $100m. The investor’s stock is now worth $25m, representing a capital gain of $23m. The investor held the stock for more than five years, so has satisfied the time requirement, but their profit was greater than $10m, so this triggers the 10x profit rule. Since their profit was 11.5x their investment, they would potentially not pay any tax on the first $20m profit but would need to pay tax on the remaining $3m profit.
Benefits of using the QSBS exemption
The QSBS exemption was created with the intention of helping companies attract investors with the tax incentives and to attract and retain key staff with employee stock options. The benefits to investors can be significant, with potentially little or no tax being payable on profits.
Caveats to keep in mind with QSBS
While the benefits of QSBS can be significant and the basic rules are relatively straightforward, as with so many things – the devil is in the detail. It is critical for companies and investors alike to make sure that those rules are being followed at all times throughout the entire life of the investment. There may be circumstances that could invalidate the QSBS status of the shares (such as some share redemptions), so it is important to be vigilant and get solid counsel from tax professionals who are experienced with QSBS. It is also important to understand the QSBS treatment (most importantly, the timing) when using a Convertible Note or SAFE (Simple Agreement for Future Equity) – you can learn about these instruments in this article.
QSBS is an opportunity that when used effectively, can lower an investor’s tax liability, and has the potential to improve capital raising opportunities for companies. But there are important rules that must be followed to achieve and maintain QSBS status, so it is vital that all parties understand the requirements and adhere to them. As with any investment, past performance is no guarantee of future performance, and any investment decision must balance the risk against the potential return. If you are interested in building your portfolio by adding investments in startups, you can find more information here on how to start angel investing and how to find opportunities for angel investing on the Propel(x) platform. Finally, this article is for informational purposes only. Your individual tax related circumstances may vary significantly and therefore please consult your tax advisor before making any investments.