Why Section 1202 and QSBS Are So Important to Startup Founders, Employees, and Investors | Nelson Mullins Riley & Scarborough LLP
With good planning (and avoiding some potential landmines along the way), Qualified Small Business Stock (QSBS) may be able to avoid paying taxes up to 100% capital gains realized on the sale of shares in a startup. This 100% exclusion has been available for startup founders, employees and investors since 2010. If the changes proposed by the House Ways and Means Committee are passed, this 100% exclusion would be reduced to 50% for taxpayers whose Adjusted gross income is equal to or exceeding $ 400,000 for all sales and trades made after September 13, 2021 (unless a binding contract to sell the shares has been entered into on or before that date). The maximum earning exclusion is the greater of (i) $ 10 million or (ii) 10 times the holder’s adjusted tax base in the QSBS. If you are a founder, QSBS should be a factor to consider when making decisions about starting your business, issuing shares, repurchasing shares and beyond.
First, the disclaimer: As with most things lawyers talk about, every situation is different and there are exceptions, details, nuances, and other considerations that are not included in this article. You should always consult a legal and tax professional to determine if and how you might benefit from the QSBS rules.
What is QSBS? Generally speaking, QSBS is a share that (A) is acquired directly (i.e. in cash or in exchange for services) (B) from a “qualified small business” (C) is held for 5 years before the sale and (D) without a disqualifying event occurs.
What does it all mean?
- Acquired directly. QSBS must generally be initially issued to you by the company directly after September 27, 2010 to be eligible for the full exclusion. In other words, if you bought your shares directly from the company and after that date, that’s fine. If you bought it from another shareholder, you probably won’t be able to benefit from section 1202. There are exceptions for certain transfers by gift, death, certain tax-exempt reorganizations or, in limited circumstances, to or from a transfer. entity, so that proper tax and estate planning can preserve QSBS treatment even after certain transfers. If you receive restricted shares as a start-up employee, those shares may also be eligible, provided that you make an 83 (b) choice or, instead of an 83 (b) choice, the restricted shares are fully acquired.
- A “qualified small business”. This is one (1) U.S. C corporation (2) engaged in a qualifying trade or business (3) with total gross assets not exceeding $ 50 million prior to issuance.
Thus, shares issued by foreign companies, S companies and LLCs cannot qualify as QSBS. However – and this is a big “however” – it is possible to convert an LLC or other unqualified company into a C company in a way that exchanges unqualified shares for newly issued QSBS. If this happens without tax deferral and at a time when the value of the unqualified shares is high enough that the basis of the new QSBS exceeds $ 1 million, then the exclusion of the QSBS gain may even exceed the typical $ 10. . millions maximum (since the exclusion will be capped at the largest 10x base). Note, conversions of S companies in particular should be given special attention, as they are unlikely to qualify the stock as QSBS in the absence of a corporate restructuring or other targeted planning. This issue is often only discovered after due diligence on an exit, when it is far too late to complete the trade and begin the 5 year holding period described below.
The definition of a skilled trade or business is quite broad and essentially requires activities outside of a few prohibited industries. Most tech start-ups will be eligible even if they are tangentially tied to some of the more common exclusions (such as the hospitality industry, personal services, financial industry, agriculture, and mining). So, for example, companies engaged directly in the provision of health or financial services generally do not qualify, but many health technology and FinTech companies do so as a software-as-a-business model. service is generally considered distinct and separate from the underlying service domain. Eighty percent of the company’s assets must be used in the active conduct of a qualifying trade or business for the duration of the taxpayer’s holding period. This is very specific to the facts, and there are strategies that companies can implement as long as they are engaged in skilled and unskilled trades or businesses.
To issue QSBS, the company must also have remained below $ 50 million in gross assets at all times prior to the qualifying issue. The previously issued QSBS does not lose its eligibility when this threshold is crossed, but the company can no longer issue new QSBS shares, even if the total subsequently drops below this number.
- Held for 5 years before sale. A holder must have held the share for a period of 5 years prior to the date of the sale for the share to qualify as QSBS. Filing an 83 (b) election will generally start the clock for restricted shares issued for services. Limited exceptions similar to the initial issuance requirement above generally apply here in the event of a transfer, but, as with this requirement, affiliate transfers should be reviewed for 1202 compliance to ensure that the period 5-year holding will be transferred to the assignee as scheduled. Some rollover transactions may preserve QSBS treatment for shares sold before being held for 5 years.
- No disqualifying event. Certain actions taken by the company may affect QSBS processing for a single holder or for a group of shareholders (or all) at the same time. In addition to the inability to maintain a qualifying trade or business as described above, buyout and takeover bid transactions (which have become increasingly common for fast-growing startups) feature a minefield of problems that can destroy the opportunity to benefit from Section 1202. For example, during the 2 year window on either side of an issue of shares to a particular holder, a redemption of any share of that holder will cancel the QSBS benefits with respect to this share issue. In addition, certain larger share buybacks occurring within a one-year window on either side of a share issue may destroy QSBS eligibility for all shares issued in that issue. Because of these rules, any proposed buyback should be discussed with legal counsel as early in the process as possible.
As mentioned above, this article does not cover all the details, rules, or exceptions that may help – or hinder – QSBS eligibility.
 QSBS issued after September 27, 2010 are eligible for the 100% exclusion, and QSBS issued after August 10, 1993 and before September 27, 2010 are eligible for a 75% exclusion. If the changes proposed by the House Ways and Means Committee are passed, the 100% and 75% exclusions would be reduced to 50% for taxpayers with adjusted gross income equal to or greater than $ 400,000 (subject to the binding contractual exception).