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October 22, 2024
In today’s competitive financial landscape, both businesses and investors are looking for strategies to maximize returns while minimizing tax burdens. One powerful tax benefit that can save owners and investors millions of dollars is Qualified Small Business Stock (QSBS).
QSBS provides investors in qualifying startups with substantial savings. It allows them to exclude large portions of capital gains from federal taxes (the greater of $10 million or 10 times the cost basis of their investment when they sell QSBS stock). This means if an investment grows significantly, the gains may be entirely free of federal capital gains taxes.
It’s important to note that the $10 million limit is a cumulative amount, and the 10-times basis limit is an annual limit. These limits are applied per equity issuer (corporation) and per shareholder.
As such, the timing of when to sell different tranches of QSBS stock, if purchased in separate transactions, is important for maximizing tax benefits. This helps combine both the cumulative and annual limitations in the most effective way.
To qualify as QSBS under Internal Revenue Code Section 1202, the stock must be issued by a C Corporation that:
For growing companies, this can attract more investment at a higher valuation by offering investors the potential for major QSBS tax benefits. Understanding all the unique considerations of QSBS eligibility requirements is critical. It can be a game changer for both stock owners and investors when it comes to maximizing their returns.
The capital gains exclusion can be massive.
Example: An angel investor invests $20 million in a company. Five years later the company is acquired, and that $20 million investment is worth $200 million. That’s a $180 million long-term capital gain. But thanks to the tax benefits of qualified small business stock, the investor pays zero federal capital gains tax!
It’s important for investors to understand that the $50 million asset threshold applies only on the day you invest.
A company has $20 million in assets when an investor makes an investment. Five years later the company is acquired, and they have $100 million in assets. The investment still qualifies as small business stock. The value of the company’s total assets doesn’t matter after the investment is made.
QSBS can provide significant tax-free gains for investors if held for at least five years. However, stock options aren’t eligible for QSBS tax benefits. Only the stock itself can be QSBS eligible. Therefore, the option or warrant must be exercised first.
Then the underlying stock issued to the option or warrant holder may be eligible for QSBS if the five-year holding period is reached. The vesting period of the option or warrant itself does not count towards the five-year holding period for QSBS treatment.
Additionally, as startups grow and go through multiple rounds of funding, their assets can increase significantly.
A company’s assets exceed the $50 million threshold by the time you exercise your options. The stock you acquire may no longer meet QSBS eligibility requirements, negating the tax benefits you can claim.
QSBS benefits are primarily a federal tax provision. Some states may not follow the same rules or offer equivalent benefits. California, for example, does not allow QSBS tax exclusions.
Given the complexities of state tax law, especially with QSBS, consulting a knowledgeable tax advisor is crucial to navigate the nuances and ensure compliance.
If a company repurchases its stock (“redemption”), it can potentially affect the QSBS status of certain shares issued during certain periods. There are two limits placed on these redemptions.
The first limit is shareholder specific. It relates to the company’s redemption of a shareholder or related person’s stock in a four-year window beginning two years before the issuance in question. If the redemption exceeds $10,000 and more than 2% of the value of stock held by the shareholder or a related party, then the issuance in that four-year window won’t be QSBS.
Bob is a shareholder in ABC, a C corporation. In 2022, Bob’s ABC stock is worth $2 million. ABC purchases $20,000 of Bob’s ABC stock as a redemption equal to 1% of the total value of ABC stock Bob held. Bob then contributes $2 million to ABC in 2023 for additional ABC stock.
In 2024, Bob’s ABC stock is worth $4 million. ABC purchases $100,000 of Bob’s ABC stock as a redemption equal to 2.5% of the total value of the ABC stock Bob held, resulting in an aggregate redemption equal to 3.5%.
Accordingly, the redemptions are not de minimis because the aggregate amount paid to Bob within a four-year period beginning two years before the 2023 issuance of ABC stock to Bob exceeds both:
As such, the stock issued to Bob in 2023 is not QSBS.
The other limit is not shareholder specific. It has two elements that are analyzed during a two-year window beginning one year before the issuance in question. The first element is that the redemption(s) are greater than $10,000 and more than 2% of the value of all the outstanding stock of the company at the time of redemption.
The second element is that the total value of all the redemptions in that two-year period exceeded 5% of the value of the company stock at the beginning of the two-year window. If both elements are satisfied, none of the stock issuances during that two-year window will be treated as QSBS.
On January 1, 2023, XYZ, a C corporation, has outstanding stock valued at $20 million. The next year, on January 1, 2024, Susan contributes cash to XYZ in exchange for XYZ stock. Finally, on July 1, 2024, when the value of the outstanding stock of XYZ is $40 million, XYZ redeems some of its stock for $2 million, representing 5% of the stock at the time of the redemption.
The redemption is not de minimis because it exceeds $10,000 and represents more than 2% of the outstanding stock at the time of redemption. Also, because the redemption represents more than 5% ($2 million/$20 million = 10%) of the value of the stock issued on January 1, 2023 (one year before the January 1, 2024 issuance of stock to Susan), the stock issued to Susan is not QSBS.
It’s important to consider how debt and equity fundraising efforts will impact a company’s total assets and QSBS eligibility. While you don’t want to impede additional cash inflow, you also want to make an informed decision. For example, a company might consider raising $45 million in an equity round rather than $50 million so that the shares issued could still qualify for QSBS.
QSBS can make a company more attractive to investors by offering significant tax benefits. This benefit may lead investors to take on more risk or offer a higher valuation.
For example: agreeing to a $50 million pre-money valuation if the stock qualifies for QSBS, compared to $40 million without it. Since after-tax returns are crucial to investors, QSBS’s ability to reduce or eliminate capital gains taxes becomes a powerful incentive that can increase valuations and investment interest.
When it comes to ensuring QSBS eligibility, companies need to be careful about investing their cash to earn a higher interest rate. Often companies look to invest their cash into long-term assets or managed portfolios to earn better returns. However, investments with longer maturity dates, such as bonds or treasuries, could potentially disqualify the company from QSBS benefits.
This is why it’s essential to be mindful of treasury management decisions. By working with knowledgeable tax professionals, companies can balance liquidity needs with business objectives to ensure investment strategies don’t inadvertently affect QSBS eligibility.
QSBS creates a mutually beneficial environment where small businesses gain access to necessary capital, and investors enjoy significant tax advantages. This makes QSBS a critical component of the investment and growth ecosystem for startups and emerging companies.
Our tax and finance professionals at Escalon can provide guidance on navigating the complexities of QSBS, ensuring that businesses or investors are maximizing the potential tax benefits while avoiding costly errors. Contact one of our professionals today and schedule a complimentary consultation.
Hugh Alexander is an accomplished tax executive and licensed attorney with over 27 years of experience in delivering comprehensive business tax services, specializing in technology-based SMBs. Known for his strategic insight and client-focused approach, Hugh expertly navigates complex tax regulations and compliance challenges. He is an active member of the Tax Sections for both the State Bar of Texas and the State Bar of Arizona, demonstrating his commitment to staying at the forefront of the industry.
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