Thinking of Selling Your Startup? How QSBS Lets You Keep More of Your Profit.

Taxes are a crucial piece of selling a business. As a result, the more planning done ahead of time before selling could have massive swings in the amount owed after the sale. If done correctly, Qualified Small Business Stock (QSBS) may be one of the best planning ideas to reduce taxes. While there are requirements to meet, setting your company up for QSBS could potentially eliminate all federal capital gains tax you could owe.

What is QSBS?

Congress created Section 1202 (and QSBS) back in 1993 as a way to spur small business growth. Since then, the provisions have changed a few times, but the main point is clear. Selling shares that qualify for QSBS status may allow you to exclude 100% of the capital gains from your federal taxes. Back in 1993, the original exclusion was only 50% of any gains. After other laws made QSBS less favorable, they increased the exclusion to 75% in 2009 and finally to 100% in 2010.

For example, if you sell your business stock for a $1,000,000 gain, how much of a tax liability could you expect? Making more than 1 million in one tax year would mean your gains are taxed at a 20% capital gains rate plus a 3.8% NII tax. To keep the math easy, that is $238,000 towards taxes the year you sell. After paying Uncle Sam, only $762,000 remains. Most people understand that taxes are a part of the financial life of business, but when there is a possibility to save $238,000 in capital gains tax, people start asking questions.

Congress capped this exclusion to the greater of $10,000,000 or 10 times the cost basis to purchase the stock. So, if you invested $2,000,000 into QSBS and sold it for $20,000,000, there would likely be no federal capital gains tax on the sale of the stock. Alternatively, if you are looking a few years out and think you could sell the company for a few million dollars, then the QSBS could be very attractive at this point.

Requirements

Knowing whether your company qualifies to issue QSBS before you sell it can help you determine what your next steps are. Assuming that making changes related to QSBS doesn’t hurt your company, planning to sell QSBS can be achievable and save a lot. Ask a tax advisor if your specific business qualifies for QSBS status. There are quite a few rules required before the tax status can be claimed. Here are only a few of them:

1. The company must be a C-Corporation. The company cannot be a Sole Proprietorship, Partnership, or S-Corporation.
2. The company must have less than $50 million in gross assets at the time stock is issued. On top of this, at least 80% of the assets must be actively used in the business.
3. The company must operate as an Eligible Corporation. Meaning that it generally cannot work in any service company like lawyers, advisors, athletics, or any other company where the skill of an employee is the business asset. Farms, banks, hotels, restaurants, and more are excluded as well.
4. The owner must hold the shares for at least 5 years. After purchasing the stock in exchange for money, services, etc., the owner must hold the QSBS for no less than 5 years from the purchase date.
5. The owner must receive shares at “original issuance”. In other words, you can’t buy shares from another person. You must “buy” them from the company.

What You Can Do

The big question owners need to answer is whether they want to sell their company. In order for QSBS to work, owners must hold the shares for at least 5 years before selling the company. Sometimes people start a company with the clarity of wanting to sell at a later point, while others do not. Since the 5-year rule is in place, however, it is a decision that cannot be made year-to-year. If you know your end game involves selling the company for a large gain, start focusing on QSBS early.

After deciding whether the QSBS is worth addressing, the second main issue is the entity status of the business. Since the business must be a C-Corporation, any company structured as a sole proprietorship, partnership, or LLC would need to file to change its entity status. This will cause a lot of unrelated changes to your business taxes, filing requirements, etc. Working with an attorney and accountant to switch to a C-Corporation can be achieved relatively easily, but understand the changes that could occur. It could entirely be the case that switching would increase taxes now, in an effort to save on taxes overall after the sale of the business.

After electing C-Corp status, issuing QSBS-eligible shares is the next critical step. The date that stock is issued is important to start the 5-year clock, as well as to ensure that the company is below $50 million in assets at the time of issuance or shortly after. To note, it is possible to roll over QSBS shares from one company to the next. It could be fairly reasonable to see a scenario where a company sells before the 5-year clock for the individual owner. As a result, they could roll their shares into a new QSB and continue their countdown.

Qualified Small Business Stock

While the 100% gain sounds very powerful, there are a lot of steps to get to that point. Make sure to work with your financial team to understand how and to what degree QSBS may help your situation. There are a lot of regulations around how to qualify, and many conversations to get to that point. However, done correctly for a few years, it is entirely possible for an owner to save six or seven figures in taxes on their exit.