Benjamin Franklin suggested that death and taxes were life’s only certainties. But perhaps his advisors didn’t know enough about the Qualified Small Business Stock (QSBS) exemption. So if you are facing a potential taxable event from shares you acquired in a private company, understanding the ins and outs of Section 1202 of the Internal Revenue Code (IRC) just might ease the pain of one of life’s inevitabilities.
Section 1202 of the IRC is commonly referred to as the QSBS exemption. If you are a founder, angel investor, or an employee of a successful early stage company, you need to be aware of certain qualifications that could help you protect up to $10 million (or 10 times your cost basis, whichever is greater) from federal taxes.
The Basic Requirements
You must meet several key requirements to benefit from the QSBS exemption. Particularly, you must have held your stock in a Qualified Small Business for at least five years. For purposes of this part of the tax code, a Qualified Small Business is defined as:
- A domestic C Corporation
- An entity with cash and other assets totaling $50 million or less, on an adjusted basis
- Any business other than: (a) services firms such as health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial or brokerage services, (b) banking, insurance, financing and similar businesses, (c) farming, (d) mining and other natural resource businesses (e) operation of hotel, motel, restaurant or similar business.
- An entity that is actively running a business. In other words, at least 80% of the assets of the firm must be used to actively run the business, not for investment purposes.
The other key requirement is to understand when and how you acquired the stock. This requirement has been in place since 1993, but it has since undergone a few improvements. The table below lays out the actual savings based on the date you acquired shares:
A Real World Example
Let’s say Mr. Jones started ABC Company on January 15, 2009, using $10,000 in cash. In October of 2010, Ms. Doe, an early employee received 200,000 options exercisable at $0.05/share which she immediately exercised. In July of 2012 Mr. Lee made an investment of $500,000 when the value of the firm was $5,000,000.
In June of 2016, the company was acquired for $100 million (we will assume that Mr. Jones received $10,000,000, Ms. Doe received $2,500,000 and Mr. Lee received $15,000,000). Champagne all around. But bear in mind Mr. Jones’ effective tax rate (assuming AMT) is 16.88% on his profits. Ms. Doe on the other hand, has an effective tax rate of 0% (federal) on her gains. Mr. Lee on the other hand has not met the 5-year holding rule; however, being an astute investor, he decides to take $10,000,000 and invest in another 3 other startups and writes them checks within 60 days of the payout. With the remaining $5,000,000 he pays long-term capital gains at 20% plus the NII tax of 3.8%. If and when the other investments pay him back, his principal in those transactions will have an effective tax rate of 0% and any gains may qualify for QSBS treatment.