Under Section 1202 of the Internal Revenue Code, $10M of capital gains from the sale of qualified small business stock (QSBS) are excluded from federal taxes, which can make QSBS a great opportunity for angel investors and small businesses alike. Tech founders especially are issuing qualified small business stock to scale their startups, but there are several parameters that small business investors must be aware of to ensure they can take advantage of this tax credit.
What is the Small Business Stock Gains Exclusion?
Initially enacted in 1993 as part of the Revenue Reconciliation Act, Section 1202 was designed to encourage non-corporate taxpayers to invest in small businesses in certain sectors. It was later amended in both the American Recovery and Reinvestment Act of 2009 and the Small Business Jobs Act of 2010, incrementally increasing the exclusion to the current 100%. In 2015, it was made permanent for all QSBS acquired after September 27, 2010, as part of The Protecting Americans from Tax Hikes Act.
What are the eligibility requirements for the capital gains exemption?
QSBS can be a smart way to invest in a startup if both the investor and company meet certain criteria. While not an all-inclusive list, here are the key requirements for taking advantage of this exemption: [1]
The company…
- Must be a domestic C corporation with gross assets that do not exceed $50 million on or immediately after issuance
- Must be in a qualifying industry such as technology, retail, wholesale, or manufacturing
- Must use at least 80% of their assets in the operations of one or more of the qualified businesses
The investor…
- Must be an individual, investment partnership, or private equity group taxed as a partnership
- Must have acquired the stock at its original issue and not on the secondary market
- Must have purchased the stock with cash or property, or accepted it as payment for a service
- Must have held the stock for at least five years
The stock…
- Must have been issued after August 10, 1993
How much of the capital gains on QSBS can be excluded?
While initially established with an exclusion limit of 50%, the law has since been amended to allow up to 100% of the capital gains to be excluded based on the issue date of the stock.
| Date QSBS Acquired | Exclusion Limit |
| August 10, 1993 – February 16, 2009 | 50% of gain |
| February 17, 2009 – September 27, 2010 | 75% of gain |
| September 28, 2010 forward | 100% of gain |
United States Code: §1202 (a)(3),(4)
Frequently, the QSBS exclusion is overlooked or identified after the sale happens, costing startup investors a material difference in their tax obligation. In cases where the full 100% exclusion is applicable, it can turn a capital gain that is taxed at 23.8% into a capital gain that is taxed at 0%, which has the effect of increasing the investment return by about 33%.
In a recent discussion with legal counsel Mike McGovern, Partner at Reiter, Brunel & Dunn, he also noted that because the startup company is taxed as a C corporation, investors don’t have to worry about phantom income (a tax principle where an investor may be allocated income for which they must pay taxes, even though no actual cash or other property is distributed to the investor). Phantom income is present only in a pass-through entity structure and therefore not a concern when investing in QSBS.
What are the advantages/disadvantages for the startup company?
While there are no direct tax benefits for the startup company itself, issuing QSBS can still be advantageous as it is an attractive selling point when raising capital. Furthermore, since the law allows companies to issue QSBS as compensation for services, it can also be used as an incentive to attract high-quality talent or to reward and retain employees.
A potential disadvantage is that in order to qualify, the company must be a C corporation, which is more complicated to initially set up and could lead to higher income taxes due to double taxation. However, proper tax planning with your CPA and accurate documentation from the onset can alleviate some of those pain points.
McGovern also noted that unlike pass-through entities (which typically include multi-member LLCs and other forms of partnerships), C corporations have additional corporate governance obligations such as mandatory annual board and annual stockholder meetings, depending on the jurisdiction.
The fine print of investing in QSBS
- As with all things tax, good record-keeping is essential. Important documents such as the original stock certificate (to show original issuance) and copies of the corporation’s financials/tax returns for the time period when the stock was issued (to show the $50M asset test is passed) will be crucial when the time comes to file for the exclusion.
- The stock cannot be purchased on the secondary market as that will disqualify the investor from the exclusion.
- When contemplating an investment in QSBS, the required 5-year holding period to claim the exclusion should be taken into consideration.
- There is a $10M cap on the exclusion; however, this can be multiplied by gifting the QSBS to family members or putting it into trusts.
- The stock cannot be held inside of another C corporation as that will disqualify the investor from the exclusion.
- If the Qualified Small Business did not originally start as a C corporation, a valuation should be done at the time they convert to a C corporation, as only the appreciation from that point forward will qualify for the exclusion.
- There are some regulations that prohibit the QSBS company from redeeming (or repurchasing) stock from its investors during the life of the corporation, prior to an exit event.
What are some other tax benefits available to angel investors?
Section 1045 also provides some relief to taxpayers who have not held their QSBS for the required 5-year period to qualify for the Small Business Stock Gains Exclusion. It allows for the taxable gains from the sale of QSBS that has been held for at least six months to be rolled into replacement QSBS, therefore deferring the investor’s tax obligation. [2]
In situations where an investment in a qualified small business does not perform successfully, Section 1244 allows the losses on the sale of the stock to be treated as ordinary losses rather than capital losses. Ordinary losses are fully deductible in the year of the loss and are not offset by capital gains. [3]
Qualified small business stock can be an excellent option when the issuing company will not have a lot of taxable income itself, and the startup investor is looking for a big exit after 5 or more years. There are, however, other situations (such as investing in a cash flow business) where different tax structures may be more tax-efficient. If you’re looking to explore the tax implications and different approaches to investing in a startup or small business, contact us today. If you’re a Founder or Entrepreneur exploring issuing qualified small business stock, we can also talk you through the tax implications for your startup.
[1] United States Code: §1202(c)(d)(e)
[2] United States Code: §1045(a)
[3] United States Code: §1244(a)
