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The qualified small business stock exclusion is an IRS provision that represents a potentially massive win for founders and early employees of private companies. 

A successful exit — whether via IPO or acquisition — is a goal for many private companies. This type of event gives the people who built the company the opportunity for a significant financial windfall. The qualified small business stock (QSBS) exclusion could help you and your colleagues cash in on your hard work. 

This exclusion may allow qualifying shareholders to avoid the capital gains tax entirely upon the sale of their shares — up to $10 million or 10x your original share purchase.  

Not every company is on the verge of being acquired. Nonetheless, understanding the QSBS exclusion can help you plan your company growth with your end goal in mind. You can start planning today for a successful exit with the lowest tax hit possible. 

We’ll share some insights on the qualified small business stock inclusion, tips on how to prepare for your exit, and highlight how Fidelity’s equity management platform can help you stay ready. 

What is qualified small business stock? 

Qualified small business stock is a type of stock that can receive favorable tax treatment when issued by a qualifying company. The shares must be in an active, domestic C corporation that meets the standards for a QSBS (more on that shortly). While this classification was introduced in 1993 to encourage investment in small businesses and startups, recent changes to the tax code made it more enticing for private companies. 

What is the qualified small business stock exclusion? 

The qualified small business stock exclusion may allow certain shareholders to exclude up to $10 million – or 10x the cost basis of the stock, whichever is greater — from federal capital gains tax when they sell the stock. This applies to stock acquired after September 27, 2010. The QSBS tax exclusion is established in Section 1202 of the U.S. Internal Revenue Code.  

Normally when someone sells their shares, they’d be subject to a capital gains tax, which can be as high as 37% for short-term assets (and up to 20% for longer-term ones). If your exit involves selling millions of dollars in shares, those taxes can really add up. The QSBS exclusion could allow you to avoid major federal taxes and keep more of your cash! 

How do I qualify for the QSBS exclusion? 

QSBS exclusion savings could be significant, but not everyone’s shares may be eligible. You can find the IRS’s full list of requirements here. We’ll provide a high-level overview: 

The private company must…. 

  • Be a domestic C corporation 
  • Be part of a qualified trade or business — most tech, consumer and life science companies do qualify 
  • Have an aggregate value that does not exceed $50 million upon issuance of stock 
  • Have at least 80% of the company’s assets used in the active conduct of one or more qualified trades or businesses 

Founders, employees and investors must…. 

  • Be a non-corporate taxpayer (founders, early employees, investors) 
  • Have held the stock for at least 5 years (stock options and restricted stock unit grants do not qualify) 
  • Purchased their stock directly from the company (i.e. original issuance of stock) 

Certain states do not recognize the QSBS at the state level. You should make sure to check your state’s status.  

3 tips for taking advantage of the qualified small business stock exclusion 

So, what can you do to better position yourself for the QSBS exclusion? We have a few ideas: 

Consult with your accountant or attorney. 

Every company’s scenario is different, and you should get information in context. We recommend that you speak with a tax advisor, accountant or lawyer before making any moves. 

Structure your company accordingly 

As you read above, your private company must be a C Corporation to receive QSBS benefits. It typically costs just $400 to get your Delaware C Corporation up and running with Fidelity.  

Maintain accurate records of company ownership. 

Understanding the qualified small business stock exclusion requires diligence from founders and early employees. As companies grow and fundraise, they’ll often have more shareholders and more entries in their cap table. Fidelity’s equity management platform can help private companies stay on top of all of their fundraising needs: 

  • Automated equity management: Grant equity and manage your cap table. 
  • Automated data room: Organize and secure key documents. 
  • Scenario planning: Prepare for your exit. 
  • Board and stockholder management: Communicate information about acquisition activities. 

Learn more about how Fidelity’s equity management platform can help you prepare for fundraising and acquisition events. 

 

Fidelity does not provide legal or tax advice. The information herein is general in nature and should not be considered legal or tax advice. Consult an attorney or tax professional regarding your specific situation. 

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