QSBS and Section 1202 for Startups

The US tax code strongly incentivizes investments into small and new businesses, like startups. When you invest in a company or receive shares in an early stage startup (as a founder, advisor or employee), and then hold the shares for 5 years before selling, you may pay 0% in federal income and capital gains tax on the profits.

This is all thanks to Section 1202, which lays out the requirements you must meet in order to qualify for an exemption from paying capital gains when you sell shares in a startup that is eligible for the QSBS exemption.

We’ll cover Section 1202’s exemption requirements below, and steps you can take to qualify for tax benefits.

When determining whether your proceeds qualify for the QSBS exemption, there are two parties you must take into consideration: Yourself, the stockholder and taxpayer; and the issuer of the stock (the corporation whose shares you hold).

Each party must meet particular requirements in order to qualify for the QSBS gain exclusion.

The issuer of the stock must:

• Be an active US C corporation. S corporations do not qualify for QSBS. Also, the corporation must be using 80% of its assets (measured in value) to actively conduct business; holding companies don’t qualify.
• Not hold over $50 million in gross assets, from the day of incorporation to the day the stock is issued.
• Issue the stock directly to the stockholder (ie. the stock is not purchased on a secondary market).
• Be engaged in a qualifying trade.

A “qualifying trade” is any line of business not included in the following:

• Personal services: Law, accounting, health, consulting—any service where the principal asset being engaged is the reputation and expertise of one or more of its employees.
• Financial services: Investment, banking, insurance, or related businesses.
• Real estate: Renting, investing in, or dealing in real estate.
• Hospitality: Including hotels, motels, restaurants, etc.
• Resource extraction: Mining, drilling, etc.
• Farming

Luckily, this list doesn’t include tech companies—meaning, founders and early employees of startups can often benefit from Section 1202.

The individual holding stock must:

• Not be a corporation. Only individuals, trusts, or pass-through entities can qualify for the QSBS tax exemption.
• Acquire the stock after 2010. Before 2010, the QSBS exemption was less than 100% of capital gains. (We cover the history of the exemption below.)
• Satisfy the holding period. To enjoy a 100% exemption, the stockholder must hold the stock for a minimum period of five years following the date it was issued.

In addition to the limits covered above, there is a maximum gain cap on all QSBS exemptions. The most you can exempt from capital gains from the sale of a single corporation’s stock is either $10 million, or 10 times the original asset value of the stock—whichever amount is greater.

If your startup is successful, or if you’re an early employee compensated with equity at a startup that succeeds, you potentially have a lot to gain from QSBS. Namely, the IRS lets you avoid paying 100% of your capital gains on that stock, provided you meet the requirements covered above.

There are a couple other benefits to qualifying for the QSBS exemption:

Your tax exclusion isn’t only limited to capital gains tax. So long as you meet QSBS requirements, you’ll also be 100% exempt from alternative minimum tax (AMT) and the 3.8% net investment income tax (NIIT).

Even if you don’t meet the 5 year holding threshold, you can use gains from selling QSBS stock to purchase new stock tax free. If you’re an electing stockholder and you’ve held QSBS stock for at least six months, you can sell it and use the proceeds to purchase new QSBS stock within 60 days of the sale. Gains that are “rolled over” in this way are not recognized—meaning, you don’t pay capital gains tax on them. You’re only required to pay capital gains tax on gains that are not used to purchase new QSBS stock.

This QSBS “rollover” provision is especially useful if you are forced to sell your stock before reaching the 5 year holding limit. To learn more about this provision, see Section 1045.

If you’re investing in new startups, Section 1202 and the QSBS exemption have a direct impact on your investment strategy in both the long term (holding stock for five years or more) and the short term (selling stock before five years have passed).

Some investors may shape their entire strategy around the QSBS exemption, investing in startups only during their early stages in order to reap tax benefits later on.

For others, QSBS may be a motivation to maintain a steady deal flow—that is, to ensure they always have the opportunity to invest in new startups suiting their portfolio. That way, in the event they’re required to sell QSBS stock in an existing investment prior to the end of the five year holding period, they can rollover the proceeds of the sale into a new investment within the 60 day window and avoid paying capital gains tax on them.

If you’re currently acquiring stock in a startup, or issuing shares to employees, it’s unlikely the pre-2010 history of QSBS exemptions directly applies to you. But, just in case you have some ancient startup stock lying around, here are the past exemption amounts:

• Capital gains from QSBS stock acquired from Aug. 11, 1993, to Feb. 17, 2009 is 50% excluded from gross income taxes and 7% of the excluded gain is subject to AMT.
• Capital gains from QSBS stock acquired from Feb. 18, 2009, to Sept. 27, 2010 is 75% excluded from gross income taxes and 7% of the excluded gain is subject to AMT.

Keep in mind that gains from all QSBS stock acquired after 2010 are exempt from AMT.

• By meeting QSBS exemption requirements, you can avoid paying capital gains on sales of startup stock.
• Broadly speaking, the most important requirement to meet is the 5 year holding period for QSBS. If you sell your stock too early, you will not be eligible for the 100% capital gains exemption.
• Even if you are forced to sell your QSBS stock early, you can avoid paying capital gains by reinvesting your profits in new QSBS within 60 days of the sale.

—

Just getting started on your journey? Learn the ins and outs of giving equity to your employees. title