Qualified Small Business Stock (QSBS), a guide for startups

We’ve been getting many inquiries about Qualified Small Business Stock (QSBS) lately, and unsurprisingly so. With the growing number of new startups across America, it only makes sense for founders to consider all the tax benefits available to them.

Qualified Small Business Stock (QSBS) represents one of the most significant tax benefits available to startup founders and investors, offering potential tax exclusions of up to $10 million or 10 times your investment basis on capital gains.

While these tax savings might seem extraordinary, they're a deliberate incentive created by Congress to encourage investment in small businesses. In this guide, we'll examine the specific eligibility requirements, benefits, and implementation steps to help you understand QSBS.

What is Qualified Small Business Stock?

The Qualified Small Business Stock is the government's way of encouraging investment into small businesses to drive economic growth. Created under Section 1202 of the Internal Revenue Code, QSBS allows eligible shareholders to exclude up to 100% of their capital gains from federal taxes when they sell their qualifying stock.

It's like finding out that your favorite coffee shop has a secret menu—it's been there all along, but you need to know what to ask for!

Historical context

QSBS wasn't always the powerhouse tax benefit it is today. When Congress first introduced Section 1202 in 1993, it offered a modest 50% exclusion. 

Fast forward to the 2008 financial crisis and the government decided to sweeten the deal. The exclusion jumped to 75% in 2009, and then to 100% in 2010 as part of the Small Business Jobs Act. What was once a nice-to-have became a must-have for savvy startup investors.

Why QSBS matters in today's startup ecosystem

In an era where startup valuations can skyrocket, QSBS has become increasingly valuable. It's not just about tax savings, it's about making early-stage investments more attractive.

For startup founders and early employees

It helps keep employees committed and engaged when they know that they could potentially keep 100% of the gains from their equity, tax-free. This is relevant for founders considering follow-on investments, as well as employees thinking about exercising their stock options.

For investors considering a stake in early-stage companies

The tax benefits can significantly improve the risk-reward equation. Instead of facing standard capital gains tax on successful investments, they could potentially qualify for substantial tax savings, making those high-risk, high-potential opportunities more attractive.

It is important to note that QSBS favor specific industries, specifically, those that scale through products, technology, or processes rather than through individual expertise or services. For example, a software platform that automates legal work could qualify, while a traditional law firm wouldn't. 

If you’re a startup founder or investor in the technology and software development space, you are more likely to be eligible for QSB status!  

How does Qualified Small Business Stock work?

When you qualify for QSBS, you can exclude up to 100% of your capital gains from federal taxes when selling your shares, potentially saving millions in taxes on a successful exit.

Consider this practical example: An initial investment of $100,000 in qualifying stock grows to $5 million over five years. Under the 100% QSBS exclusion, the entire $4.9 million gain could be exempt from federal capital gains tax. Without this qualification, the same gain might incur over $1 million in tax liability.

The benefit is capped at the greater of $10 million or 10 times the adjusted basis in the stock, applied per issuer and per taxpayer. 

Further, the portion of gain excluded under QSBS isn't subject to the Alternative Minimum Tax (AMT). This is huge for high-income earners who might otherwise lose tax benefits to AMT calculations.

Qualifying for QSBS tax benefits

Let's get deeper into the nitty gritty. While the potential upside of a QSBS exemption can be pretty substantial, not all small businesses can easily qualify with its stringent eligibility requirements.

QSBS requirements for issuing corporation

On the side of the issuing corporation, you must meet the following qualifications:

• Domestic C Corporation status. Your company must be a U.S.-based C corporation when the stock is issued. This is a foundational requirement. S corporations and LLCs don't qualify, even if they later convert to C corps after issuing stock.
• Asset value limit. The company's total gross assets must stay under $50 million both before and immediately after issuing the stock. Keep in mind that this threshold applies at the time of issuance. Future growth won't disqualify previously qualified shares. However, changes in your 409A valuation could affect QSBS status for new stock issuances.
• Active business engagement. At least 80% of your company's assets must be actively used in running the business. This means actually operating a business rather than just holding investments or assets. 
• Qualified trade or business types. Industries that generally qualify are tech and software development, manufacturing, research and development, product-based businesses, and innovation-focused companies. In other words, businesses that scale through products, technology, or processes rather than through individual expertise or services. 
• State tax treatment. Not all states conform to Section 1202. Fully confirming states like New York, Florida, and Washington, follow the federal QSBS treatment to the letter. If your business is California, the state doesn't recognize QSBS at all. Pennsylvania, Massachussets, and New Jersey apply their own tax rules, while Mississippi only partially conforms. When planning to apply for QSBS, start with where your business is registered, whether it’s in a conforming or non-confirming state.

QSBS requirements for shareholders

Investors and shareholders can benefit from QSBS when the following requirements are met:

• Stock acquisition. You can only claim QSBS benefits for stock acquired directly from the company, not from other shareholders on the secondary market. Qualifying acquisitions include purchasing shares with cash or receiving shares as equity compensation for services to the company.
• Five-year holding period. To claim the full QSBS tax benefits, you need to hold your shares for at least 5 years. This is a firm requirement. Even if you meet all other criteria, selling before the 5-year mark means you won't get the full tax exclusion.

Filing for QSBS: next steps

Let's say you tick all the boxes and you're ready to apply for QSBS. What are the first things to do? These steps are essentially for the founder, who must first ensure that his startup is eligible for QSB status. 

Pull up your cap table

As a founder, you need to double-check your eligibility. Pull up your cap table and verify that five-year holding period. This is where having a clean, well-maintained cap table becomes crucial.

Still have your cap table in a spreadsheet? It’s time to shift to cap table software! When millions in tax savings are on the line, you don’t want to rely on manual spreadsheet math. 

Pro-tip: Having a dynamic cap table platform —and more importantly, keeping it clean— isn’t just about organization. It’s a key compliance factor for QSBS eligibility. 

Obtain or refresh your 409A valuation

As mentioned above, to be eligible for QSBS, your company's gross assets can't exceed $50 million at the time of stock issuance or immediately after. Your 409A valuation helps prove you were under that $50 million threshold.

Regular 409A valuations not only help with option pricing but also create a paper trail for QSBS qualification. We often see founders tracking this carefully through their cap table to ensure they don't accidentally cross this threshold. Keep those valuations handy. They're your best defence if the IRS comes knocking.

Get professional help

As always, we highly recommend consulting with legal and tax advisors. If you're looking at a large gain, multiple states, or any kind of corporate reorganization, the cost of good tax advice is a rounding error compared to your potential tax savings.

We've seen too many founders try to DIY this and leave money on the table. If you’re looking for help with QSBS, reach out so we can connect you with our network of advisors and experts.

What about the QSBS attestation letter?

A QSBS attestation letter is a formal document confirming that the issued shares meet QSBS qualification requirements at the time of issuance.

Take note: You don't need an attestation letter to qualify for QSBS. The QSBS attestation letter is a document that proves you are already a qualified small business (QSB). This document is issued to your shareholders to prove their QSBS eligibility when they eventually sell their shares.

The importance of strategic planning and documentation

Success with QSBS is all about preparation and documentation. From day one, you need to maintain detailed records of your stock issuance, including original stock certificates, board resolutions, purchase agreements, Section 83(b) elections, 409A valuations, etc.

You'll want to keep evidence of your company's qualifications, such as balance sheets showing gross assets, business activity records, corporate tax returns, and annual financial statements. 

Having all of these important documents stored securely in one place, having a single source of truth for all your equity transactions, and maintaining a clean cap table is highly recommended.

As a trusted partner for US startups, Cake Equity is here to help you navigate QSBS, maintain a clean cap table, and maximize your tax benefits. Book a demo today and see how we can support your growth.

Future of QSBS

The QSBS landscape continues to evolve with proposed legislative changes and shifting policy considerations. Smart founders and investors stay ahead of the curve by maintaining thorough documentation, conducting regular monitoring, seeking professional guidance when needed, and leveraging technology to manage their equity.

Remember, while this guide gives you the basics, tax matters are complex. Always consult with tax professionals for your specific situation.

Our team is actively engaging with startup founders, investors, and industry experts and holding workshops on matters related to startup equity. Follow us on LinkedIn and look out for opportunities to network and learn.