If you are an early stage startup employee, then you’re reading the right blog. That’s because the tax savings for qualified small business stock (QSBS) can be huge.
We’ve outlined the qualification requirements for claiming the QSBS designation. If you think you qualify for QSBS, make sure to get in touch with us at Visor.
Company-Level Eligibility Requirements
For your stock to be eligible for the tax benefit as defined in Section 1202 of the tax code, your ownership interest must have been received when the company qualified as a “small business”. For our purposes, a small business is defined as:
- C-corporations based in the U.S.
- Having raised no more than $50 million of financing (technically, can’t have over $50 million of cash and other assets on its balance sheet)
- Primarily participating in an “active business”, rather than an “investment business”
- Active in an industry other than the following:
- Services (such as health, law, engineering, accounting, etc.)
- Any banking, insurance, financing, leasing, investing, or similar business
- Mining or extraction businesses
- Operating a hotel, motel, restaurant, or similar business.
- Note: Only the original issuance stock qualifies. Secondary investments are not eligible.
If you were an early employee or investor in a US-based startup, then there is a very good chance that your equity qualifies as QSBS.
Holding Period Requirements
For your stock to be eligible for the tax benefit as defined in Section 1202 of the tax code, you must hold the stock for at least five years before selling it.
Employee Stock Options
A typical scenario for an early stage employee is to receive Incentive Stock Options (ISOs), with a four-year vesting period and one-year cliff. For purposes of the holding period requirement, we measure starting with the exercise date. That has two big implications:
- The option must be exercised while the company still meets the above eligibility requirements. Specifically, if you do not exercise until after the company has over $50 million of assets, then your stock will not meet the QSBS test.
- The clock on the holding period does not start until the options have been exercised. So you have to wait five years from exercise. Don’t confuse the grant date or vest date as the starting point for the holding period requirements.
Acquisition Within 5 Years
If your startup was acquired prior to your holding period reaching five years, there is still hope for qualifying for the preferential tax treatment.
If you received stock in the acquiring company, such as in an all-stock deal, then your holding period may transfer over. Meaning, if you then hold the new stock for long enough so that your total holding period exceeds five years, you can still qualify for the tax savings.
A couple of limitations though:
- Only the gain up until the time of the acquisition will qualify for preferential tax treatment. Any subsequent appreciation of the new company stock that was received via the acquisition will be subject to regular capital gains tax treatment.
- It is important it obtain a copy of the purchase price agreement. Only Section 351 & Section 368 transactions qualify for holding period rule carryover.
How the QSBS Tax Savings Are Determined
Now for the fun part. If you’ve determined that your stock qualifies for QSBS treatment, the next step is to calculate your tax savings.
When you qualify for QSBS, a portion of your capital gain recognized upon selling the stock is excluded from the capital gains tax. Congress has changed the tax law for QSBS several times, with the result being that exclusion amount, as well as the implications on the Alternative Minimum Tax, vary depending on when you bought the stock (or exercised your options). The different tax treatments are listed in the following table, and we’ve outlined an example below to help illustrate the savings:
|Acquisition Period||Max Exclusion||Cap Gains Reduction||AMT Add Back|
|Before Feb 18, 2009||Greater of $10mm or|
10x base investment
|Feb 18, 2009 - Sep 27, 2010||Greater of $10mm or|
10x base investment
|After Sep 27, 2010||Greater of $10mm or|
10x base investment
The above table gives us three important pieces of information:
- The exclusion amount is significant. The first $10 million of capital gains can fall under the special QSBS treatment (or even more if your investment was over $1 million).
- The percentage of the eligible gain that is then excluded from the capital gains tax ranges from 50-100%, depending on when your initial investment took place. Investments after Sep 27, 2010, can have 100% of the gain excluded from tax (meaning the first $10 million in capital gains would be tax free!).
- There is an Alternative Minimum Tax adjustment for investments prior to Sep 28, 2010. The AMT is a complex parallel tax calculation that everyone must pay if the tax liability is larger than the standard tax calculation. In this case, we have to add 7% of the gain back into the AMT calculation. What that means is the full benefit will be partially offset.
Let’s say you received 10,000 stock options in your startup and you exercised all 10,000 shares at a price of $1 per share in Jan 2011. In 2018, your startup IPOs, and your shares are now worth $20 each.
If you sell all your shares, your gross proceeds are $200,000, and your long-term capital gain is $190,000. Most people are subject to either a 18.8% or 23.8% (inclusive of the 3.8% Affordable Care Act net investment tax) capital gains tax bracket. With a gain of $190,000, that would equate to a tax of $35,720-45,220.
With the QSBS provision applied, the tax would be $0. Saving $35k+ ain’t bad!
As much proof as possible, such as a letter from your company stating that it is a qualified small business as of a certain date (or at least that it has not broached the $50 million asset hurdle), should be kept. This will make your life easier down the road when you sell and claim the QSBS tax savings, especially if the IRS decides to audit you.
- The tax savings from QSBS can be significant. So don’t overlook this tax benefit. Many accountants are unaware of it too, so they might not recognize your eligibility unless you point it out to them.
- If you’re an early stage employee with unexercised stock options, QSBS might be an added incentive to exercise your options now rather than waiting until your company no longer qualifies. Exercising options is a risky decision, so you need to make this decision fully accounting for the possibility of losing your investment, but the upside is better with the added tax savings from QSBS.
Have questions? Contact Visor. We have lots of experience working with employer equity compensation and can help make sure you’re getting the most out of your stock.
Anything the article didn’t address? Leave a comment below and we’ll reply ASAP!
Done filing taxes alone? New clients can prepay $99 to lock in your spot!