Meet QSBS Requirements (Optimal Tax Treatment)
The QSBS tax exemption can allow you to exclude 100% of capital gains (up to $10 million; perhaps more). But you must meet a large number or criteria.
Strategy Overview
Qualified Small Business Stock (QSBS) provides for preferential tax treatment by excluding up to 100% of capital gains up to $10 million (and sometimes more). It's one of the most impactful tax strategies one can utilize, but also one of the most difficult to achieve. Strategically, one needs to first understand each of the requirements, and then make sure the eventual sale of stock qualifies for the exclusion.
Tax Details
QSBS is one of the most attractive tax optimization opportunities that exists, enabling an individual to exclude up to $10 million (and possibly more) of capital gains from taxation at both (i) federal level, as well as from (ii) most states. However, there are a large number of criteria that one must meet in order for the sale of stock to qualify for the exclusion. A more fulsome checklist can be found here, but the few key items we most frequently encounter and strategize around for clients are:
Your company must be a C corp. If its not, it's unlikely to qualify.
You must purchase your shares (i) directly from the company (ii) prior to it ever having $50 million or more in assets. Purchases must be directly from the company (e.g. a stock option exercise), not from another shareholder (e.g. secondary transaction). And you must purchase those shares prior to the company ever having more than $50 million in gross assets (this includes cash from VC raises).
Your company cannot operate in an excluded industry (which is a bit tricky). QSBS criteria exclude a number of industries from qualification, including (but not limited to) health, law, engineering, real estate, accounting, finance and financial services, consulting, and food/restaurants.
Note: Some technology companies that operate in these industries still qualify (it's a bit complicated). If your company operates in a disqualified industry, we suggest you ask your leadership if they have conducted a QSBS analysis and/or work with a financial advisor to help guide you through decisioning and strategy.
You must own shares for at least 5 years. This is from the date of your purchase (i.e. typically the exercise of your stock option(s).
Note: married couples may be able to claim up to $20 million. The QSBS tax exclusion is per taxpayer ID. A married household has two taxpayers/IDs, and may be able to double the maximum exemption up to $20 million. This isn't always 100%, however, and can be impacted by multiple factors (e.g. when you were married, the state you live in). Consulting a professional to carefully plan in this scenario is highly encouraged.
Key Benefits
Allows for exclusion of capital gains, which can completely eliminate taxes on highly appreciated stock. This can result in millions of dollars in tax savings for some individuals with very large gains.
Opportunities may exist to expand the QSBS exclusion beyond $10 million. Strategies such as QSBS stacking may enable you to further increase your tax savings via QSBS.
Key Considerations/Flags
Requires holding a concentrated stock position for 5+ years. If liquidity events occur prior to the 5 year mark, participating will invalidate QSBS, but not participating will increase your concentration and investment risk.
You must meet a large number of criteria. Achieving every one of the QSBS criteria is complicated, making this one a more complex and challenging tax strategy to achieve and optimize for.
Strategy: When to Consider This and When to Avoid It
If you have the capital to exercise your stock options (or RSAs) prior to a QSBS disqualifying event (mainly, the company raising in excess of $50m) and you believe in the company's long-term business prospects.
If you have tolerance and ability to maintain a concentrated startup stock position for 5+ years.
If your company, or your stock purchase, would not qualify for QSBS; or if there is material risk the company may not maintain QSBS eligibility over the holding period.
If you have limited risk tolerance, don't believe in the company's long-term business prospects, and/or desire or need to sell some of your position to diversify.
Example
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