An obscure tax exemption called 'QSBS' can save you millions when you sell your startup. Here are the 4 basic criteria to follow to make sure you get it.
Qualified Small Business Stock, or QSBS, is something every founder and early-stage investor should know about.
The little-known tax exemption lets these early shareholders avoid paying long-term capital gains taxes to the federal government when they sell their shares. Some states allow you to wave long-term capital gains taxes as well with QSBS.
The tax break is potentially huge and applies to at least $10 million in the shareholder's profits or up to 10 times their original investment, whichever is bigger.
That means, if you sell your startup for $10 million and you own 100% of the shares, you can potentially pocket all $10 million, minus what you initially paid for the shares. Without QSBS, you'd be giving giving roughly one-third of your payout away in taxes (20% in federal, 3.8% for the Obamacare levy, plus up to 13.4% in state depending on where your business is owned and operated).
Not every small business qualifies for QSBS. The company needs to be set up in a very specific way to reap the federal tax benefits. There are four main criteria you and your startup need to meet:
You need to receive shares in the company when it is still small â when that company has gross assets of $50 million or less. If you get shares of a company like Airbnb right now, for example, it's too late to qualify for QSBS. Your startup also has to use at least 80% of its assets to conduct its business. So no hoarding cash that doesn't actually contribute to the company's operations.2).The company has to be set up as a C corporation. If your company is set up as a partnership, limited liability company or another so-called "passthrough" that, unlike a C corporation, doesn't pay taxes at the entity level, no dice.Your startup has to actually create or manufacture stuff, like new forms of technology or widgets. And it has to be in a field that qualifies for the benefit. Service firms in law, finance, architecture, accounting, and health care (i.e. doctors' offices) don't qualify. Neither do real-estate investment trusts, sales companies, restaurants, hotels or oil and gas extractors. Cooley's Lee said that while the benefit is mainly for technology companies, he has a lot of brick-and mortar manufacturing companies in the Midwest that qualify for QSBS too.You generally have to hold onto your stock for at least five years before selling it. There are a couple ways around this qualifier, though (more on that below). But if you're granted stock options, and not actual shares, your payout horizon is much longer -- the 5-year holding period starts the day you exercise them, not the day they're granted. Which means QSBS typically has the most bang for the buck when you're a founder, angel investor or board member, since those are the people that typically get actual stock in a seed company.There are ways around the 5-year rule, along with a means to make your family members rich from your qualifying QSBS.