The Advantage Of QSBS Election For Early Stage Investors

 

What is QSBS?

Through a series of bills enacted over the past several years, Congress has attempted to incentivize taxpayers to invest in small businesses by creating generous tax benefits. One of the most lucrative benefits, although often overlooked by investors and tax advisors, is provided by section 1202 of the Internal Revenue Code (“IRC”) which generally provide a complete exemption from federal income tax on gains from the sale of stock in a U.S corporation.

According to section 1202 of the Internal Revenue Code, the following conditions must be met:

  • The stock must be in a domestic C corporation, and it must be a C corporation during substantially all the time you hold the stock.
  • The corporation may not have more than fifty million dollars in assets as of the date the stock was issued and immediately after.
  • Your stock must be acquired at its original issue.
  • During substantially all the time you hold the stock, at least 80% of the value of the corporation’s assets must be used in the active conduct of one or more qualified business.

Elaborating more on the last point, active conduct means a qualified business cannot be an investment vehicle or inactive business. The business also must be a qualified trade or business. It cannot be, for example:

  • A service business in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more employees;
  • A banking, insurance, financing, leasing, investing, or similar business;
  • A farming business;
  • A business involving the production of products for which percentage depletion can be claimed;
  • A firm operating a hotel, motel, restaurant, or similar business.

Stock qualifying as QSBS that have been held for about at least five years when sold has a portion of the gain, or in some instances, all of the gain can be excluded from federal tax. The capital that is left over is then taxed at a twenty-eight percent rate. The maximum gain eligible for exclusion on any one investment is the greater of ten million dollars or ten times the taxpayer’s adjusted basis in the stock.

For example, if you invested $250,000 in a qualifying start-up (for 10%) and the start-up sold 5 years later for $15 million, you would have a gain of $1.25 million on your $250,000 investment or a return of 6x your money. If you made the QSBS election, you would pay no tax on the $1.25 million – if not, you would owe capital gains on $1.25 million or pay approximately $250,000 in tax (reducing your net return to $1 million).

QSBS treatment, more often than not, can provide significant tax savings to an individual investor’s private investment portfolio. While this article addresses the benefits available under section 1202, there are other sections which may provide benefits as well, including section 1045 for the rollover of gain from one qualified small business stock election to another.

Investors ought to carefully consider the tax opportunities when looking at investing in private, early-stage companies, and insist that the management teams of those companies maximize the potential benefits for the investors.

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