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Imagine investing in a startup, exiting five years later with a 10x TVPI, and not having to pay a dime in federal taxes on those capital gains. This scenario is possible thanks to something called the qualified small business stock gain exclusion.
In this guide, we’ll explore what qualified small business stock (QSBS) is and how its possible tax benefits can apply to venture investing. We'll also look at the numerous conditions that must be met in order to claim these benefits.
Qualified small business stock refers to shares in a business that meets the requirements of a “qualified small business” (QSB) under Section 1202 of the Internal Revenue Code (IRC). For this reason, QSBS is also sometimes referred to as “Section 1202 stock.” To be eligible, the stock must meet the full IRC Section 1202 Qualified Small Business Stock checklist. The criteria include:
Investors holding such QSBS—if they meet certain criteria themselves—can enjoy a 100% capital gains tax exclusion up to the greater of:
Note that the investor must have obtained the QSBS on or after September 28, 2010 to be eligible at 100% exclusion.
The idea behind such incentives is to promote investments in small businesses, such as early-stage tech startups.
Simply holding QSBS does not automatically entitle an investor to its tax benefits. The shareholder must also meet the following criteria:
The investor must also hold the QSBS for at least five years before liquidating it. The holding period can begin from the purchase date, vesting date (in the case of options and RSUs), or exercise date (for convertible securities).
However, if the sale happens before the five year QSBS holding period is over—but after six months from obtaining the QSBS—the holder can still enjoy the tax benefits if they meet the requirements of a QSBS rollover. Also called a “Section 1045 rollover,” the rules allow investors to defer gains on the sale of QSBS stock to the extent they invest those gains into another qualified small business within 60 days.
If the above QSBS rules for both the issuing corporation and the holders are met, then investors can enjoy a QSBS gains exclusion of up to the greater of $10M or 10x the original purchase price of the shares.
This 100% capital gains tax exclusion also covers the Alternative Minimum Tax (AMT) and the Net Investment Income Tax (NIIT)–meaning that gains from the sale of any QSBS will not be subject to either the AMT or NIIT. Keep in mind that these qualified small business stock gain exclusion caps are calculated on a per issuer basis—not per year basis. Even if an investor progressively sells their QSBS over several years, the maximum capital gains tax exclusion will not change.
The sale or transfer of an investor’s equity interest in a VC fund, or any partnership, that holds QSBS does not count as a QSBS sale. For a QSBS sale to occur, the fund must have specifically liquidated its relevant QSBS holdings and allocated capital gains from the sale to its partners. In this case, the amount of possible QSBS tax exclusion the LP can claim would be listed on a Schedule K-1 issued by the fund.
Imagine a VC fund invested $1M in a startup that qualified as a QSB at the time of investment. 7 years later, the startup goes public with a multi-billion-dollar valuation. Assume that, after dilution, the fund’s initial $1M investment is now worth $201M—for a total gain of $200M. The fund also exits its investment on the first day of trading and allocates the return amongst its partners.
For simplicity, let’s say that there are only 10 LPs in the fund and that they are entitled to 80% of the total gain (with the general partners taking the remaining 20% as carried interest). Each LP thus has $16M in capital gains.
Without the qualified small business stock gain exclusion, the total amount of tax that each LP would have to pay on that $16M gain would be (assuming the highest long-term capital gains tax bracket and that all of the gain is subject to the net investment income tax):
(20% Capital Gains Tax + 3.8% Net Investment Income Tax) x $16M Capital Gains = $3.808M Total Tax Payable
However, given that the requirements for QSBS gain exclusions were met, each LP can exclude $10M of that $16M capital gain. Therefore, the total amount of capital gains tax payable would be:
(20% Capital Gains Tax + 3.8% Net Investment Income Tax) x ($16M - $10M) Capital Gains = $1.428M Total Tax Payable
That’s a total tax savings of $2.38M per LP.
The same goes for the fund’s GPs. If we assume there are 2 GPs of the fund, then each would have a capital gain of $20M. Each GP would thus also get $2.38M in tax savings (as the total capital gains per general partner exceeds the maximum QSBS exclusion cap).
These benefits to investors are a huge incentive for startups to qualify themselves as QSBs. In fact, it’s not uncommon for investors to ask for representations and warranties from the startup stating that the securities being acquired are QSBS or even that it will take reasonable efforts to qualify the stock as QSBS. An example:
“The Company shall use commercially reasonable efforts to cause the shares of stock issued pursuant to the Purchase Agreement, as well as any shares into which such shares are converted, within the meaning of Section 1202(f) of the Internal Revenue Code (the “Code”), to constitute “qualified small business stock” as defined in Section 1202(c) of the Code””
While the tax benefits possible from the QSBS exclusions are highly attractive, there are certain considerations to keep in mind:
A stock redemption—where a company redeems shares from shareholders —can affect QSBS status. Redemptions that can jeopardize QSBS status are:
To support such QSBS exclusion claims, it’s important startups keep all relevant financial statements and supporting documents that show they fulfilled all the QSBS rules at time of stock issuance and for the duration of the time eligible investors hold the stock. Investors may also want to include QSBS representations, warranties, and covenants in the financing documents.
Note that before 2010, the capital gains tax exclusion was lower at 50% and 75%—with a percentage of the excluded gain also subject to AMT. The Biden administration’s recent tax plan included amendments that would slice the current 100% exclusion cap in half. In other words, the current rate should not be assumed permanent.
At present, qualified small business stock gain exclusion rules offer a huge benefit for venture investors, with the potential to literally save them millions in federal taxes. But to claim such savings, it’s crucial to first understand all the corresponding criteria and conditions to ensure such QSBS exclusion claims can be properly supported.
AngelList is not a tax advisor. Specific circumstances related to Schedule K-1 should be directed to a professional tax advisor.