Introduction
Qualified Small Business Stock (QSBS) is a term that most startup people have at least heard before. And for good reason: it’s the best tax break around. Yet, despite its frequent mention, its often tough for startup equity shareholders to determine if their shares are eligible.
Traditionally, answering those questions would have meant engaging a specialist accounting firm and spending $30K+ figures and several months of your valuable time. But not anymore. We at Valur have made the process fast, easy, and low cost. For between $3,750 for individuals and $12,500 for companies, we will analyze a company’s cap table to identify eligible shareholders and share grants, making it easier for everyone to take advantage of these benefits.
If you are interested you can get your QSBS Assessment started here. Otherwise read on for more context on QSBS and understanding what determines your eligibility.
What Is QSBS?
The Qualified Small Business Stock Exemption, or QSBS, allows some startup shareholders to eliminate 100% of their federal and state income tax on gains from the sale of equity. (A few states do not recognize QSBS or apply a modified version.)
The precise size of the exemption depends on your cost basis and the ultimate size of the capital gain. The baseline is that you are exempt from tax on the first $10 million of capital gains. Your exemption may be larger, though — you can take the greater of that $10 million deduction or 10 times your cost basis.
The basic $10 million exemption will be most applicable to founders and early employees; the cost-basis rule may be more helpful, in practice, later-stage employees and investors who have a higher cost basis.
Learn more about QSBS here.
Why Does The QSBS Exemption Exist?
Congress enacted the Small Business Stock Tax Exemption in 1993 to encourage investment in specific businesses. It did this by providing a simple tax benefit: Anyone who starts, invests in, or works for these businesses can exclude certain gains from federal tax when they sell their shares (provided they meet certain conditions, which we’ll outline below).
Although the aim was to encourage small business investment, Congress did not make eligibility easy to understand. For that reason, in most cases you’ll want a formal assessment to confirm that your shares are (or are not) eligible.
That’s where Valur comes in. We are experts in startup and small business tax, and we do QSBS assessments at a fraction of the cost of traditional service providers. Here’s what that entails.
What Is A QSBS Assessment?
A QSBS assessment is an evaluation process that determines whether a particular stock qualifies as QSBS under the regulations set forth by the IRS. This involves scrutinizing various aspects of the company and the shares.
- Original issue requirement: The taxpayer must have received the stock directly 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 before the sale or exchange. (The clock starts when the actual shares are received; in the case of options, the relevant date is when the options are exercised, not when they are granted.)
- Domestic C corporation: 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 for substantially all of the taxpayer’s holding period. This shouldn’t be a significant barrier for most people; virtually all U.S.-based startups are C corporations when they take their first venture funding, which will be enough to qualify as QSBS.
- “Active business” and “qualified trade or business” requirements: During the taxpayer’s holding period, the issuing company must engage actively in a “qualified trade or business.” Most professional service firms, finance, investment management, and hospitality businesses will not qualify, but most technology companies—even those serving those disqualified fields—are typically fine.
- Business valuation requirement: At all times before and immediately after the issuance of the taxpayer’s stock, the corporation’s adjusted basis in its gross assets, including gross income, must not exceed $50 million. This provision can be complicated, but a good, rough heuristic is that you will qualify if you were issued your stock before your company raised $50 million in a single investment round. Still, the best way to figure this out will be to ask your company’s finance team, which is part of our job during your assessment.
- State tax rules: Most states follow the federal QSBS tax code 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 to receive a state and a federal income tax break on QSBS stock.
- Other: Their are other key rules that companies have to follow ranging from how share redemptions are handled that are important to examine.
Why QSBS Assessment Is Important for Startups & Employees
- Wealth Creation: Knowing if your shares are QSBS eligible can increase your post-tax proceeds 50% or more. Unfortunately too many QSBS eligible shareholders sell their equity and pay their taxes and leave life changing wealth on the table because they don’t know about QSBS or if their shares are eligible.
- Serving Shareholders: Making eligibility clear will help employees and investors take advantage of QSBS if it is available, and it will also help them form a coherent long-term financial plan.
- Hiring and Retention Incentive: Confirming for employees that their shares are eligible — or that they will be if they hold for five years — can encourage them to join your company, or to stay on, by increasing the value of vesting shares.
Why QSBS Assessment Is Important for Venture Firms
- Maximizing Returns: Knowing which assets are QSBS eligible can help funds craft an appropriately diversified portfolio, maximize returns, and better serve LPs.
- Clarity: Being well-versed in QSBS regulations helps venture firms make it easy for their LPs to stay in compliance with their tax filings and investment allocations.
Conclusion
A QSBS assessment is an essential process that impacts stakeholders in different ways. For stock owners, it’s about getting the maximum financial benefits from their equity. For startups, it’s about maximizing returns and reducing uncertainty for their shareholders and employees. And for venture firms, it’s about serving their LPs and regulatory compliance. Valur understands and serves all of these groups, which is why we’ve invested in making QSBS assessments quick, easy, and inexpensive. Get your QSBS assessment here.
About Valur
We’ve built a platform to give everyone access to the tax and wealth-building tools typically reserved for wealthy individuals with a team of accountants and lawyers. We make it simple and seamless for our customers to take advantage of these hard-to-access tax-advantaged structures. With Valur, you can build your wealth more efficiently at less than half the cost of competitors.
From picking the best strategy to taking care of all the setup and ongoing overhead, we make things simple. The results are real: We have helped create more than $3 billion in additional wealth for our customers. If you would like to learn more, please feel free to explore our Learning Center. You can also see your potential tax savings with our online calculators or schedule a time to chat with us!
