Starting and growing a company takes a lot of hard work and dedication and, if successful, offers immense benefits. If you’re a founder or executive and you reach the point where the business meets or exceeds your expectations, it’s important to understand all the tools available to you, especially something called Qualified Small Business Stock (QSBS).
A QSBS is a type of stock in a small business that provides certain tax benefits to investors, which can be a powerful tool for founders and executives looking to maximize the value of their equity. In this article, we’ll explore what a QSBS is, why you should think about it early on in your business, the tax benefits, and more, so you can make informed decisions about your financial future.
Why Is QSBS Important to You?
QSBS can help a taxpayer exclude from taxable income a specified percentage of the gain realized on the sale of a small business under §1202. For example, if you follow the requirements, the first $10 million of your capital gain can be excluded from both federal tax and state tax here in Utah (and in many other states). That’s right, $10 million!
If you don’t qualify under 1202, then that gain is subject to 20% capital gain, 4.85% Utah income tax, and 3.8% net investment tax. On a $10 million transaction, qualifying your shares as QSBS can save you $2,865,000 in taxes!
Moreover, with proper tax and estate planning with trusted financial and legal advisors, it is possible for a taxpayer to multiply this benefit by transferring his or her shares into trusts for the benefit of family and friends. Imagine a Utah tech entrepreneur who is married with three children. The entrepreneur creates a certain type of trust for each child and transfers a portion of his or her QSBS shares to each trust. With this planning in place, up to $40 million of the gain can be excluded from tax for over $11 million in tax savings.
For the rare entrepreneur with a significant tax basis in the company, remember that the exclusion is for the first $10 million in gain or 10 times their tax basis—allowing those entrepreneurs even greater potential tax savings.
What Is Qualified Small Business Stock?
QSBS is a type of stock in a small business that provides immense tax benefits to investors, so long as the following requirements are met:
- The business must be a domestic C corporation. The stock must be original issue stock, meaning it must be issued in exchange for cash, property, or services and cannot be acquired through an acquisition of assets.
- The business must have gross assets of less than $50 million at the time the stock is issued.
- The business must be engaged in an active trade or business and cannot be an investment company or engaged in passive investment activities.
- The company must be a certain type of business; think of software or technology businesses, not professional services, banking, or healthcare businesses.
- To receive the full benefits of QSBS treatment, the stock must be held by the investor for more than five years.
Although these are the five main requirements, there are details and intricacies to each qualification, so it is essential to work with a qualified professional in the future to ensure your shares are QSBS.
Plan to Use QSBS Ahead of Time
The best time to think about using QSBS is as early as possible—even at the formation of your company or when you receive a significant equity compensation package. Even if you aren’t close to the level of financial success you hope to achieve, it will make the process easier for you and your partners if you know exactly what you need to do to qualify for the above-mentioned tax benefits. Additionally, if you have dreams or plans of selling the business one day, it will only help you if you start planning for that sale sooner rather than later.
Obtaining and Losing QSBS
Even if you didn’t start the company, you can still obtain the benefits of QSBS so long as all pertinent requirements are met. For example, if you receive equity compensation in the form of non-qualified stock options, incentive stock options, restricted or performance share units, your shares could one day qualify as QSBS. However, please keep in mind that with stock options the five-year holding requirement does not begin and the $50 million Gross Asset Test does not occur until your shares are exercised or converted (or for share units, at vesting). There is an exception if you make a Section 83(b) election on unvested restricted stock, but otherwise unvested options do not start the clock.
There are a number of other examples that could help or hinder your QSBS prospects, which is why it’s imperative to work with qualified professionals who can help you navigate the process so you can reap the full benefits.
We Can Help Maximize Your Equity
At Solidarity Wealth, we work with successful founders, entrepreneurs, and executives to help maximize their equity, lower their taxes, and better plan for their financial futures. If you’d like to see if Qualified Small Business Stock is right for you and your company, reach out to us at firstname.lastname@example.org or call 385-374-1665 to schedule a discovery call.
Jeff McClean is a co-founder, partner, and wealth advisor at Solidarity Wealth, a privately held, independent wealth management firm that serves as a multi-family office to some of the Mountain West’s most successful families, technology entrepreneurs, and executives. He specializes in helping clients navigate the unique challenges of significant wealth and better predict their financial future.
As a former tax and estate planning attorney, Jeff is uniquely qualified to advise clients on their overall wealth to help them understand how the pieces of their financial puzzle fit and work together to meet their goals and build the best plan for their future. He values building personal relationships with clients and offering recommendations as a trusted partner, focusing on helping them grow in their financial confidence and freedom to choose their path.
Jeff holds a bachelor’s degree in accounting from Brigham Young University – Idaho and a Juris Doctor with honors from the University of Texas School of Law. Outside of work, he is a huge sports fan and enjoys spending time with family, golfing, and skiing. He also serves as President of the Salt Lake Estate Planning Council and is a frequent speaker on tax and estate planning topics. To learn more about Jeff, connect with him on LinkedIn.
Solidarity Wealth is a registered investment adviser. This material is solely for informational purposes. Advisory services are only offered to clients or prospective clients where Solidarity Wealth and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Solidarity Wealth unless a client service agreement is in place.