Qualified Small Business Stock (QSBS) is a tax incentive that I have found few are aware of and even less understand. Once you start to unpack it, you realize its importance if you spend time investing in early stage companies as it can lead to a 100% capital gains exemption on federal and state income tax (depending on what state you reside in). I am a huge fan of QSBS as it is an incentive that is available to all of the key stakeholders that sit around the table of early stage companies (Founders, Angel Investors, Seed Venture Funds, Series A & B venture funds, Employees, Limited Partners, etc.) QSBS also acts as a flow through vehicle meaning you can pass along the tax exemption to others depending on how your transaction is structured. This means that if you are a venture capital fund the gains can pass through to your limited partners, thus accelerating your overall returns to your limited partners (to the extent that your limited partners are US taxpayers). As a caveat this is not something that a fund would report as returns, but you could message the eligibility of the gain that could be exempted.
What is QSBS? QSBS was written under Section 1202 of the tax code as an incentive to attract capital to startups to spur economic development and innovation. The exemption is now exempt from federal & 43 states capital gains tax, alternative minimum tax (AMT), and net investment income tax (NIIT). The exemption can exclude up to $10M or 10x the basis of the investment.
There are lots of criteria and rules that need to be adhered to for QSBS eligibility (and our friends at QSBSexpert.com can help navigate some of those). But here are a few key ones:
- Company must be a Domestic (United States) C-Corporation and have their assets / focus be in a qualified industry (software companies seem to check the box most of the time).
- Company must be smaller than $50M in gross assets immediately after stock issuance and the stock must be purchased from the company directly.
- You need to hold the stock for at least five years. If you don’t hold the stock for five years, you become eligible for a 1045 exchange, which is a similar concept to a 1031 exchange in real estate.
Example: A venture capital fund with 10 limited partners invested into qualifying QSBS. The fund exited the investment after five years with a total gain of $100M. Assuming the LPs have a pro-rata share within the fund each of their gains would be $10M.
Without QSBS, each would owe about $2.98M (20% Federal capital gains tax, 3.8% NIIT, and 6% Georgia capital gains tax = 29.8% x $10M). With QSBS, the tax drops to $0, saving each investor $2.98M in taxes.
As a result, the savings in taxes increase the after-tax IRR from ~48% to ~58%, a 23% lift!
As a limited partner you should not have to put in any extra time or effort for filing your taxes or determining if your investments are eligible. The initial assessment for QSBS is usually up to the investment target to determine and for the investment fund to confirm. There is a growing popularity for stock purchase agreements to include a QSBS rep, that counsel should push to include for 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”
That being said, many funds are not familiar with Section 1202 / QSBS, so feel free to say hello, or pass this article on to them and we are glad to chat with them.
In summary, the government has provided an underrated tax incentive to early-stage investors that if maintained can unlock a material increase in after-tax returns. This is also a great program as it aligns all of the parties. While today we talked about limited partners and venture funds, QSBS is also eligible for angel investors, founders, and even extends to employees. All of which should be aware of the potential 100% capital gains tax savings on the appreciation of their stock.
More to come in the future, two additional articles that I am already thinking about are related to the 1045 exchange and what happens when you exit through a stock for stock exchange.
Do not consider anything on this post as tax or legal advice.
About the author: Zach Posner is a Co-Founder & Managing Partner at The LegalTech Fund where he invests in companies that are transforming the world of law (and thinks a lot about QSBS for all of the stakeholders that The LegalTech Fund works with) and can be reached here.
This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.