Did you know part of your startup sale can be excluded from federal taxes?
A provision in the tax code helps minimizes taxes for the wealthy investor and startup employee upon a stock sale. It’s called the Qualified Small Business Stock (“QSBS”) exemption. Most startup employees have no idea they can use this!
This allows a C Corp shareholder to exclude up to 100% of their gain from taxes, if they meet certain parameters.
To qualify for the QSBS exclusion, five criteria must be met (legal jargon to follow):
1. The stock must have been directly acquired via an original issuance from a U.S. C corporation (Sec. 1202(c)(1));
2. Both before and immediately after stock issuance, the C corporation’s tax basis in gross assets did not exceed $50 million (Sec. 1202(d)(1));
3. The C corporation and shareholders must consent to supply documentation regarding QSBS (Sec. 1202(d)(1)(C));
4. The C corporation conducts certain qualified active trades or businesses (Sec. 1202(e)); and
5. The stock must have been held for more than five years (Sec. 1202(b)(2)).
You can find a tax checklist for the requirements HERE.
Many early stage startups will meet these criteria. If you are FinTech, then you may need to do more analysis to see if you can be treated as QSBS. This goes for the other excluded industries as well.
Once you determine the startup is a QSBS, you can exclude part of the gain dependent upon when you bought the stock.
Federal Exclusion of QSBS Gain
| Acquisition Period | Percent Exclusion (Regular Tax) | AMT Add-Back |
| Before Feb 18, 2009 | 50 | 7 |
| Feb 18, 2009–Sept 27, 2010 | 75 | 7 |
| Sept 28, 2010 and later | 100 | 0 |
The remaining capital gain is taxed at a 28% capital gains rate instead of the 15%/20% long-term rate. This may sound like you are worse off, but the benefit comes in the amount of gain you can exclude from the taxable calculation.
Most sales for higher wage earners will trigger AMT. For AMT purposes, 7% of the excluded gain is added back to taxable income for the computation of stock sold before Sept 28, 2010.
You will also need to consider the Net Investment Income (“NII”) tax at 3.8%. This will be applicable under all scenarios when the taxable income threshold is met.
Let’s see how Qualified Small Business Stock works through an example.
Assume you sell your startup and meet the 5 criteria for considering this stock qualified small business stock.
Your regular ordinary income is about $500,000 with your spouse.
Your share of the business gain is $350,000.
Purchase Date: January 3, 2009
Your estimated tax would be calculated as:
$350,000 x 50% exclusion = $175,000 excluded gain
$350,000 – $175,000 = $175,000 taxable gain
$175,000 x 31.8% (28% capital gains rate + 3.8% NII tax) = $55,650 regular tax
$175,000 x 7% AMT add back x 28% capital gains tax = $3,430 additional minimum tax (AMT)
Estimated total tax due on business gain: $59,080
Estimated effective tax % of gain: 16.88%
Purchase Date: January 3, 2010
Your estimated tax would be calculated as:
$350,000 x 75% exclusion = $262,500 excluded gain
$350,000 – $262,500 = $87,500 taxable gain
$87,500 x 31.8% = $27,825 regular tax
$262,500 x 7% AMT add back x 28% = $5,145 additional minimum tax
Estimated total tax due on business gain: $32,970
Estimated effective tax % of gain: 9.42%
Purchase Date: January 3, 2011
Your estimated tax would be calculated as:
$350,000 x 100% exclusion = $350,000 excluded gain
$350,000 – $350,000 = $0 taxable gain
$0 x 31.8% = $0 regular tax
$0 x 7% AMT add back x 28% = $0 additional minimum tax
Estimated total tax due on business gain: $0
Estimated effective tax % of gain: N/A
What if you didn’t claim the Qualified Small Business Stock exclusion?
Your estimated tax would be calculated as:
$350,000 x 20% long-term capital gains rate x 3.8% NII tax = $83,300
Estimated total tax due on business gain: $83,300
Estimated effective tax % of gain: 23.8%
Now that you see the benefits, what do you need to do to claim the QSBS exclusion?
Make sure you have documentation to backup your belief you meet the 5 criteria.
This may include:
- proof of initial capitalization at your purchase date (i.e. 3rd party valuation documentation – tying to your 83(b) election valuation)
- proof of stock purchase date (stock certificates or copy of check) and
- certification from the company that they are a U.S. C Corporation (i.e. IRS Form W-9)
Hire a tax preparer for the year in question. The simplified example above does not include a discussion of how each state may further tax your business gain. They will also make sure they have the documentation to support the QSBS exclusion on file in case of audit.
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The above discussion is for informational purposes only. Recommendations are of a general nature, not based on knowledge of any individual’s specific needs or circumstances, and there is no intent to provide individual investment advisory, supervisory or management services.
If you live in a state with it’s own form of state AMT, this further complicates the matter. AMT calculations can be difficult and you may need professional help, such as that of an accountant, tax attorney, or someone experienced in complex tax returns.
