Yes, you read that right. If you’re talking tax breaks that could save you a million dollars when you sell your company, that list isn’t very long. QSBS is one of those. Founders can bank huge dollars using the QSBS tax advantage.
QSBS stands for Qualified Small Business Stock. It’s also referred to as IRC 1202, one of the IRS’ Internal Revenue Codes.
Let’s break down what you need to know about QSBS.
QSBS Stock Options: It’s one of the most valuable tax breaks for founders.
QSBS is a gamechanger for founders, angel investors, and early-stage employees of c-corporations.
There are 4 criteria to qualify for the QSBS tax break.
- Your business is a c-corporation.
- You bought your stock before the company has $50M in assets, or vested in your stock before $50M in assets. (The key here is filing an 83(b) Election. More on that below!)
- Hold your shares for 5 years.
- You acquired the shares directly through the company, not through a secondary offering.
Your clock on your capital gains starts with your 83(b) Election.
83(b) Elections are a really important piece of paperwork for founders.
Filing an 83(b) Election doesn’t just start the clock for short-term and long-term classification of your shares. It also starts the 5-year clock for QSBS qualification. (And a full exemption with QSBS can exclude up to $10M in proceeds!)
In addition, if you don’t file an 83(b) Election, you have to wait 5 years from the date that your founders stock vests. So, say it vests over 4 years. That means you have to hold this stock for 9 years to qualify for this million-dollar savings.
Learn more about 83(b) Elections here.
Understanding how QSBS applies to your investors is important when negotiating.
In the early rounds – before you have $50M in assets – any investor who pays you directly for your shares also starts the QSBS clock.
For individual investors, they will also receive the maximum exemption ($10M in proceeds) if they hold their shares for 5 years.
For funds, that’s calculated at the LP level. If you get into the inner workings of their business, each of their investors is given up to $10M in tax exemption. So, say a fund has 100 LPs – that’s 100 members that can receive exclusions up to $10M (translating to almost unlimited capital gains).
And yes – funds are aware of this. As a founder, you should also be, too, when thinking about valuation.
One other thing to think about is – QSBS will not apply to investors in the round that takes you over $50M in assets.
As people are investing and you’re putting more rounds together, you need to think about some of the thresholds that your investors are facing.
One of the cool things for your investors is they, too, can take advantage of the $10M tax free if they hold your stock for over 5 years. On top of that, for LLCs, SPVs, or funds that invested in you, that $10M limit applies to each of their investors individually.
For example, a fund that has 10 members who equally invested in it could exclude the first $100M in proceeds from their investment.
Build your stock option plan so that your employees can early exercise their shares.
Qualified Small Business Stock should impact your decisions when building your stock option plan, too. If you allow your employees to early exercise in the stock option plan (and they exercise their shares before you have $50M in assets), they start their QSBS clock. All they have to do is hold those shares for 5 years, and then your employees can benefit from QSBS tax breaks, too.
What is QSBS?
So let’s break down QSBS. The way I like to do this is talk about a real example, because then it kinda becomes clear. Let’s say Greenlight did a seed round in 2017 at $7.5 million. Anybody that invested or got founder shares and did their 83 B election or any employees that exercise their option before the seed round should qualify. And all the investors / angel investors before that should qualify for QSBS. They should have started their clock, their five year clock. As long as the seed round didn’t take them over $50 million in assets, they qualify.
Fast forward to 2018, Greenlight did their Series A, and it was about a $16 million round. So getting close to borderline to the $50 million in assets probably so you have to check that.
Fast forward to 2019, they do the $54 million round. Nobody in that round can take advantage of QSBS. It’s definitive now — they have $50 million in assets as a result of that because they got $50 million in cash. So anybody that didn’t file their 83 B can’t take advantage of that by that date…can’t take advantage of this anymore… even if they wait out the holding period. Anybody that didn’t file the 83 B and isn’t vested, no longer can take advantage of that QSBS. So this is just a huge missed opportunity for those people in that chain if they didn’t file the 83 B or they didn’t have an ability to exercise their stock options or didn’t exercise their stock options before they cross that $50 million threshold.
For all of those other people that DID this, there’s a huge value that has been created for them because they get to exclude individually the first $10 million of proceeds from their tax bill if they sell their stock after that five year period.
What are the criteria you have to meet for the QSBS tax break?
- You have to be a seed corporation.
- You have to have bought your stock before the company has $50 million in assets or vested in your stock before they have $50 million in assets.
- You have to hold the shares for five years.
- You can’t have acquired the shares in a secondary offering (so you have to acquire them directly from the company).
So if you meet those four criteria, you can qualify for saving millions of dollars!
What are QSBS considerations for founders and co-founders?
For a founder, following your 83 B election doesn’t just start the clock for short term and long term class of your shares, but also starts the five year clock for QSBS classification. If you start it now by filing the 83 B election, you could qualify for QSBS in five years. If you don’t file the portion of your founder stock that vests — say it vests over four years — you could vest over four years, then start the clock. And then five years later. So almost nine years, you would have to wait and hold the stock to be able to qualify for this million dollar savings.
What are QSBS considerations for employees?
A really crucial thing to think about when you’re designing your stock option plan is your employees and whether or not you’re gonna allow your employees to early-exercise their options. So remember the QSBS clock — the five years you have to hold your stock — does not start for an option holder until they exercise their shares. So if you don’t allow early exercise, they might vest over four years. The first time they could exercise their shares might be four years from now and then they exercise and their clock would start and they’d have to hold them for five more years. So nine total years to take advantage of the QSBS. If you design your option plan so they can early exercise, your earliest shareholders or employees that got options might choose to exercise those early and start that clock. That starts their capital gains clock, and it starts the QSBS clock. So then they would only have to hold those shares for five more years. The other thing that this allows them to do is exercise the shares before you hit that $50 million in an asset threshold. Remember if they exercise after that threshold, they don’t qualify for QSBS.
What are QSBS considerations for investors?
Now how QSBS applies to your investors is also really important for you to understand as you’re negotiating. In the early rounds, before you have $50 million in assets, any investor who pays you directly for your shares will also receive the maximum. They can exclude $10 million of proceeds from their tax calculation if they hold that stock for over five years. So if you get into the inner workings of their business, each of their investors has that exclusion to work with.
Qualified Small Business Stock is very nuanced.
If you read everything up until this point, it’s clear that QSBS has some pitfalls you need to avoid. But, we know this tax advantage is something that you, your investors, and your employees cannot afford to lose.
That’s why we’re ready to help! Sign up for our free CFO office hours on our website to talk through any of your questions.