With the Qualified Small Business Stock Exemption, you could pay zero taxes on the sale of $10 million of equity — and protect more with advanced planning.
✅ Key Takeaway: Using the Qualified Small Business Stock (QSBS) Exemption, you can pay 0% federal and state taxes on most of your startup equity if you have held it for five years. And you can even multiply that protection by gifting equity to a Charitable Remainder Trust—the tax exemption is potentially unlimited.
The Qualified Small Business Stock Exemption is the single most important tax rule for many startup founders, investors, and employees. The QSBS rule allows some owners of startup equity to eliminate 100% of the taxes—state and federal—on the greater of their first $10m of gains per asset or 10x the cost basis of an asset. Generally, $10m of gains tends to be the more common scenario for early employees and a 10x cost basis may be more applicable to later-stage employees that have a higher cost basis.
It's important to note that the QSBS exemption is currently one of many items proposed by the current administration to undergo a variety of structural changes. The proposed changes mean there will still be benefits to having QSBS eligible stock, but the tax-free benefit will be limited to a smaller sum of the gains. We'll be sure to keep you updated in real-time as these potential changes become law! Until then and for 2021, the following QSBS rules apply.
We'll explain how QSBS works and how you can ensure that you get this protection when you sell. First, though, let's take a look at some context: Why does QSBS exist at all?
Why does the QSBS exemption exist?
Congress enacted the Small Business Stock Tax Exemption in 1993 to encourage investment in specific types of small businesses. It did this by providing a simple tax exclusion: Anyone who starts, invests in, or works for a small business can exclude certain gains when they sell their shares (provided that they meet certain conditions--see below).
And although Congress probably didn't have tech startups in mind when it created the exemption the year before Netscape Navigator was born, the exemption applies to shares in all kinds of "small" businesses, including young tech startups (and Congress confirmed as much when it renewed the exemption as part of the Small Business Jobs Act of 2010).
How does it work?
Today, the primary benefit for holders of QSBS—and it is a huge benefit—is the zero-percent tax rate on eligible gains up to $10 million per company, per person. We don't have to tell you that this tax break is a major boon for employees of high-growth technology or technology-enabled startups. And it applies to most startup equity earned during a company's early years.
Ways to do even better
You might imagine that it's hard to beat a 0% tax rate on $10 million in gains. And you'd be partly right: If you live in a high-tax state, that could mean an extra $3.7 million in your pocket.
But what if there were a way to multiply that exemption? As we've mentioned, the QSBS exclusion is $10 million per taxpayer, per company. One way to take advantage of this detail is to claim the exclusion for multiple investments--if you're an early employee, you get up to a $10 million exemption for each.
Let's look at an example. Say you are an employee of a very successful Food Delivery startup that's nearing an IPO, but before that you worked for a fast-growing Data Analytics start-up. Let's assume you paid next to nothing for your shares, because you early exercised, and today each company's stock is worth $5 million (that's a total of $10 million between the two). First off, congratulations, you're receiving a massive landfall, but what does this mean for applying for the QSBS exemption? Assuming your shares meet the QSBS criteria (it's always worth checking with your company), the proceeds from your sale would be tax-free and you would have $10 million in your pocket. If the price of the stock went up and each company's shares were worth $10 million each, you could sell it all and realize up to $20 million of gain tax-free. (That's $10 million per asset.)
What to do now
Timing is key to the QSBS multiplier strategy, and there's an important tradeoff:
Are my assets eligible?
The IRS documents on QSBS can be tough to follow--shocker, we know--and there are nuances to the requirements. We've done our best to make them digestible here, but please reach out if you have questions and we'll gladly help you understand if your shares are eligible and how to stack your QSBS exemptions.
Original issue requirement. The taxpayer must have received the stock at original issue from the company (that is, not in a secondary sale) in exchange for money, other property, or services. Most equity grants to founders, employees and investors will qualify.
Five-year holding period. The taxpayer must have held the stock for at least five years prior to the sale or exchange. (The clock starts from the time the stock was exercised, not when it was granted.)
Domestic C corporations only. The issuing company must be a domestic C corporation at the time of issue, at the time of the taxpayer’s sale or exchange, and during substantially all of the taxpayer’s holding period. This shouldn't be a major barrier for most people; virtually all U.S.-based startups are C corporations when they take their first venture funding, and that'll be enough to qualify as QSBS.
Active business and qualified trade or business requirements. At all times during the taxpayer’s holding period, the issuing company must be actively engaged in a "qualified trade or business." Most professional service firms, finance, and investment management businesses, and hospitality businesses will not qualify, but most technology companies—even tech companies serving those disqualified fields—typically are fine.
Small business requirement. At all times before and immediately after the issuance of the taxpayer’s stock, the corporation’s adjusted basis in its cash and other assets must not have exceeded $50 million. This provision is complicated, but a good, rough heuristic is that you will qualify if you were issued your stock before your company raised $50m in funding. Still, the best way to figure this out for sure is to ask your company's finance team.
State tax rules. Most states follow the federal QSBS rules and exempt qualified gains from state taxes as well. But some states--California and Pennsylvania, for example--don't, and others, such as New Jersey, impose additional requirements.
✅ Key Takeaway: Using the Qualified Small Business Stock (QSBS) Exemption, you can pay 0% federal and state taxes on most of your startup equity if you have held it for five years. And you can even multiply that protection by gifting equity to a Charitable Remainder Trust—the tax exemption is potentially unlimited.
The Qualified Small Business Stock Exemption is the single most important tax rule for many startup founders, investors, and employees. The QSBS rule allows some owners of startup equity to eliminate 100% of the taxes—state and federal—on the greater of their first $10m of gains per asset or 10x the cost basis of an asset. Generally, $10m of gains tends to be the more common scenario for early employees and a 10x cost basis may be more applicable to later-stage employees that have a higher cost basis.
It's important to note that the QSBS exemption is currently one of many items proposed by the current administration to undergo a variety of structural changes. The proposed changes mean there will still be benefits to having QSBS eligible stock, but the tax-free benefit will be limited to a smaller sum of the gains. We'll be sure to keep you updated in real-time as these potential changes become law! Until then and for 2021, the following QSBS rules apply.
We'll explain how QSBS works and how you can ensure that you get this protection when you sell. First, though, let's take a look at some context: Why does QSBS exist at all?
Why does the QSBS exemption exist?
Congress enacted the Small Business Stock Tax Exemption in 1993 to encourage investment in specific types of small businesses. It did this by providing a simple tax exclusion: Anyone who starts, invests in, or works for a small business can exclude certain gains when they sell their shares (provided that they meet certain conditions--see below).
And although Congress probably didn't have tech startups in mind when it created the exemption the year before Netscape Navigator was born, the exemption applies to shares in all kinds of "small" businesses, including young tech startups (and Congress confirmed as much when it renewed the exemption as part of the Small Business Jobs Act of 2010).
How does it work?
Today, the primary benefit for holders of QSBS—and it is a huge benefit—is the zero-percent tax rate on eligible gains up to $10 million per company, per person. We don't have to tell you that this tax break is a major boon for employees of high-growth technology or technology-enabled startups. And it applies to most startup equity earned during a company's early years.
Ways to do even better
You might imagine that it's hard to beat a 0% tax rate on $10 million in gains. And you'd be partly right: If you live in a high-tax state, that could mean an extra $3.7 million in your pocket.
But what if there were a way to multiply that exemption? As we've mentioned, the QSBS exclusion is $10 million per taxpayer, per company. One way to take advantage of this detail is to claim the exclusion for multiple investments--if you're an early employee, you get up to a $10 million exemption for each.
Let's look at an example. Say you are an employee of a very successful Food Delivery startup that's nearing an IPO, but before that you worked for a fast-growing Data Analytics start-up. Let's assume you paid next to nothing for your shares, because you early exercised, and today each company's stock is worth $5 million (that's a total of $10 million between the two). First off, congratulations, you're receiving a massive landfall, but what does this mean for applying for the QSBS exemption? Assuming your shares meet the QSBS criteria (it's always worth checking with your company), the proceeds from your sale would be tax-free and you would have $10 million in your pocket. If the price of the stock went up and each company's shares were worth $10 million each, you could sell it all and realize up to $20 million of gain tax-free. (That's $10 million per asset.)
What to do now
Timing is key to the QSBS multiplier strategy, and there's an important tradeoff:
- The first step is to get in contact with someone at your company and ask if your shares qualify for QSBS. You can attempt to work through the criteria yourself but that's the fastest route to an accurate answer.
- There are additional strategies for maximizing the QSBS exemption on the off chance your shares are going to be worth more than $10 million. It's known as QSBS stacking and may be incredibly valuable if you have more than $10 million of gains. Read more on this strategy here.
- In short, getting started early--even if it's only the planning phase, will help you avoid missing out on these potentially life-changing tax savings.
Are my assets eligible?
The IRS documents on QSBS can be tough to follow--shocker, we know--and there are nuances to the requirements. We've done our best to make them digestible here, but please reach out if you have questions and we'll gladly help you understand if your shares are eligible and how to stack your QSBS exemptions.
Original issue requirement. The taxpayer must have received the stock at original issue from the company (that is, not in a secondary sale) in exchange for money, other property, or services. Most equity grants to founders, employees and investors will qualify.
Five-year holding period. The taxpayer must have held the stock for at least five years prior to the sale or exchange. (The clock starts from the time the stock was exercised, not when it was granted.)
Domestic C corporations only. The issuing company must be a domestic C corporation at the time of issue, at the time of the taxpayer’s sale or exchange, and during substantially all of the taxpayer’s holding period. This shouldn't be a major barrier for most people; virtually all U.S.-based startups are C corporations when they take their first venture funding, and that'll be enough to qualify as QSBS.
Active business and qualified trade or business requirements. At all times during the taxpayer’s holding period, the issuing company must be actively engaged in a "qualified trade or business." Most professional service firms, finance, and investment management businesses, and hospitality businesses will not qualify, but most technology companies—even tech companies serving those disqualified fields—typically are fine.
Small business requirement. At all times before and immediately after the issuance of the taxpayer’s stock, the corporation’s adjusted basis in its cash and other assets must not have exceeded $50 million. This provision is complicated, but a good, rough heuristic is that you will qualify if you were issued your stock before your company raised $50m in funding. Still, the best way to figure this out for sure is to ask your company's finance team.
State tax rules. Most states follow the federal QSBS rules and exempt qualified gains from state taxes as well. But some states--California and Pennsylvania, for example--don't, and others, such as New Jersey, impose additional requirements.
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