💸 How Qualified Small Business Stock rewards patience with big-time tax exclusions

☕ Good morning!

Welcome back to another week of Making Sense of Your Money, where we’re cooking up tax tips hotter than the air fryer you left on for too long.

Imagine the satisfaction of selling your startup shares and legally never paying tax on the profit. It might sound like fiction or something where the catch is lurking around the corner, but what we’re about to write about is actually a federal government incentive. 

Welcome to the world of Qualified Small Business Stock (QSBS), where the IRS offers you a rare opportunity to shield up to $10 million (or more) from federal capital gains taxes.

The aforementioned catch is actually a set of eligibility requirements that include the following. 

First, the company issuing the stock must be a domestic C corporation actively conducting business (service industries like law and finance, and a few others are ineligible.)

The company’s assets can’t exceed $50 million at the time of the stock issuance, and you must purchase the stock directly from the company—not from a secondary market. 

Hold your horses for at least five years, or you’ll miss out on the full tax benefits.

The real advantage of QSBS is its tax exclusion. 

If you’ve been lucky enough to pick a winner, the substantial gains from your investment could also lead to a sizable tax bill.

Without QSBS, those gains would be subject to federal capital gains tax—long-term capital gains tax up to 20%, short-term gains tax up to 37%, plus an additional 3.8% for Net Investment Income Tax (NIIT) if you’re a high earner. 

But with QSBS, those taxes can be completely wiped out for eligible gains.

For example, let’s say your $50,000 angel investment made ten years ago is now worth $10,000,000.

That’s a big-time win, but although it’s plenty to celebrate, the fact that your $9,950,000 capital gain amount (likely fully taxed at 20%) will get $1,990,000 taken out for taxes may slightly rain on your parade. 

Now, if the company you invested into and how you purchased (or were compensated in) the stock met the criteria, you wouldn’t have to pay a dime on that gain– nearly $2,000,000 more in your bank just for the proper setup.

Venture capitalists and angel investors particularly love QSBS for this reason; the exclusion can boost after-tax returns and turn a great investment into an outstanding one.

You may have noticed you can also get paid in QSBS, which sounds like a pretty advantaged comp structure over the standard ISOs and RSUs.

⚠️ Truth be told, QSBS isn't a popular form of compensation for several key reasons

QSBS can only be issued by C corporations with gross assets under $50 million at the time of issuance. Many companies, especially startups and tech firms, opt for other corporate structures like LLCs or S corporations, which don’t qualify for QSBS, which excludes a significant portion of potential companies from using QSBS as a compensation tool.

The QSBS rules are also pretty complicated and require meticulous adherence to specific criteria, and many employees and companies would prefer to avoid the uncertainty of whether the stock will ultimately qualify for the tax exclusion.

Employees could lose out on the potential tax benefits if a company inadvertently violates one of the eligibility requirements, which would be a chaotic situation, as you can imagine. 

Also, since QSBS stock must be held for at least five years to qualify for the full tax exclusion, it’s one of the longest-duration requirements for tax-friendly equity compensation, such as ISOs and RSUs. 

While QSBS offers substantial federal tax benefits, many states don’t conform to these federal rules, so you may still be liable for state taxes depending on where you live. 

🏃 The Rollover Option

What if your investment doesn’t pan out, or you want to reinvest in a different opportunity before the five years are up?

 Enter Section 1045 of the tax code. 

This allows you to defer taxes by rolling your QSBS gains into another QSBS investment. 

Essentially, you can kick the tax can down the road—just make sure to reinvest within 60 days of the sale.

The rollover option also gives you a countermeasure for the five-year holding period requirement.

The five-year holding period locks you into the stock regardless of market conditions. 

As you can imagine, a lot can change in five years in startup land. If the market crashes during your holding period, your gains—and tax benefits—could vanish. 

A rollover gives you the ability to access the gains of one investment and keep the party going with another, albeit in a fairly short time window.

Making Sense of QSBS

Here’s the deal: If you acquire stock directly from a qualified small business and hold it for at least five years, you can potentially exclude up to $10 million in gains (or 10x your investment) from federal taxes. 

By playing your cards correctly on the front end and with a little bit (frankly, a lot) of luck, you could significantly enhance the multigenerational wealth that comes from a windfall success. 

However, it’s not all sunshine. 

Think of QSBS as a high-stakes chess game. Each move—whether it’s when you acquire the stock, how you structure your investment, or when you decide to sell—can have significant consequences. 

Without careful planning, you might find yourself caught in a trap, whether it's from unexpected tax liabilities, changes in the company’s QSBS eligibility, or shifts in the market that affect your long-term strategy.

If you’re on the fence about making a decision either as an investor or as someone about to receive compensation in QSBS, it’s worth exploring the options in detail with a financial planner and don’t forget the importance of monitoring the company’s ongoing compliance with QSBS rules. 

Curious about how your wealth strategy stacks up? We’re here to help. Book a Free Financial Analysis.

Even if you’ve done everything right, the company could inadvertently disqualify itself from QSBS status by exceeding asset thresholds or shifting its business model. 

This is where regular check-ins with your financial and legal advisors come in handy, making sure that you’re always one step ahead and ready to pivot if necessary.

With the right guidance and a bit of luck, QSBS could be a game-changer in your wealth-building strategy, but like any game worth playing, it’s essential to know the rules inside and out before you make your move.

Until next week!

Dan Pascone

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This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

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