Tax-Free Investment

YESSSS it is possible to make a “tax-free investment” without needing to qualify as a 501(c)(3) nonprofit, government entity, or investing in municipal bonds. Navigating the tax code is like playing chess, you need to have a strategic gameplan with various scenarios mapped out to make your next move. No, we aren’t talking about loopholes, tax shields, or tax evasion. The tax code was written and is continuously updated not to award or punish taxpayers for making money, but to create a utilitarian system that provides incentives for contributing capital to projects, programs, and professional establishments for the betterment of our society.

One of those incentives is under Section 1202 of the tax called and is called Qualified Small Business Stock (QSBS). The tax benefits of investing in a stock that qualifies as QSBS is up to a 100% capital gains tax exclusion on the sale of the stock. There are a group of requirements for the investment to qualify but it is worth it to do your due diligence before investing. Below are the guidelines to follow or to be aware of:

  1. Qualified entity structure
  2. Qualified industry
  3. Qualified size
  4. Active trade or business
  5. QSBS acquisition criteria
  6. QSBS timeline
  7. QSBS gain exclusion cap
  8. Percent of gain excludable

When it was originally established the QSBS capital gains tax exclusion was and still is meant to incentivize investors to pour capital into technology and innovation. An example of a QSBS investment would be a startup that is building a SaaS platform or a biotechnology company in the R&D stages. Generally stock traded on a public stock exchange would not qualify unless there is a direct listing where the company is selling stock directly to an investor.

To put the potential tax savings of a QSBS investment in perspective, assume you investment $100k in a startup business, and in 5 years the investment was sold for $1.1M. That is a great return of $1M but a big chunk of your returns are going to the government. If the investment is QSBS then you will save upwards of $238k on taxes, depending on your state. Most states, 44, conform to the Section 1202 tax code, saving another $50k+ in taxes.

This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.

About Brett Calhoun

Brett Calhoun is a licensed CPA/ABV and holds an MBA from the University of Missouri. Mr. Calhoun has experience as an operator with startups, venture capital experience, and experience advising growth to mature companies’ management on financial reporting, tax, and valuation issues.