Ways Financial Advisors are Suggesting to Plan for Potential Changes to QSBS

Ways Financial Advisors

Proposed legislation making its way through the Senate has the potential to significantly lower the tax benefits of investing in the startup ecosystem. However, some accountants, financial advisors, and investment experts think with some perceptive, preemptive planning, many investors may still be able to reap the benefits of capital gain tax exemptions even if the proposed legislation passes.    

Proposed Legislation Changes

The proposed legislation as of now, founder stock holders that qualify under the QSBS tax code and with a yearly income of $400,000, or with trusts or estates, can enjoy 100% capital gain exemption on investment gains when they sell after five years. However, the Build Back Better bill has proposed restrictions on special stocks, also known as founder stock. Founder stock is different than routine shares inside a publicly-traded company. Founder stock is given to early founders and investors of a startup. There are two key differences that allow founder stock to differentiate from common stock sold in a secondary market. The first key difference is founder stock can only be issued at whatever its face value is; secondly, they can be issued with a vested schedule. When Qualified Small Business Stock (such as founder stock) qualifies and meets the five-year holding period. It will be eligible to collect up to $10 million or ten times the original investment amount (whichever is more) free of capital gain tax.   

The proposed BBB legislation would only protect half of an investor’s gains instead of the original 100% capital gains tax exemption that qualifies under QSBS. 

QSBS and Opportunity Zones

If the BBB bill was to pass through the Senate, some high-level accountants and financial planners are exploring ways that investors may still benefit from tax exemptions. 

Some strategists think the benefits of the remaining 50% QSBS capital gains exemption and the benefits in the Opportunity Zones (OZ) tax code could combine in a feasible way to maintain significant tax exemptions for investors. 

Opportunity Zones is a tax code created in 2017 under the Trump administration. This tax code allows fund and business investors settled in low-income areas to be exempt from paying capital gains taxes on their profits after ten years. 

How the Tax Code Combination could Benefit Investors

Theoretically, investors with trusts and a net worth over $400,000 would sell their founder stock that is QSBS and pay the capital gains tax on the 50% from their investment gain. Then they would roll the remaining amount of money from that investment over into an OZ fund. The IRS requires that this must happen within 180 days. Then after a ten-year time frame, all the appreciation on that amount of money would be unburdened from more capital gains tax. Some financial strategists think that this investment adjustment could potentially save much of the tax-free reward of the founder stock. 

Some financial advisers also conjecture that there may be another option to navigate a lower tax exemption if the proposed changes were to pass. In theory, a founder stock seller would set up an OZ fund as a limited liability company (LLC) or a partnership to invest in businesses or property that qualifies under OZ guidelines. Then as that business becomes profitable, the investor would convert it to a C corporation. Once that occurs, the investor would change the LLC shares to a special stock.

The thought process behind these preemptive financial moves is that swathing a QSBS founder stock investment into an OZ fund would cut the time from ten years to five years for gaining tax-free exemptions. 

Financial experts think moving investment capital around in this manner would allow an investor (after at least ten years) to inform the IRS that the money from the founder stock in the OZ fund should be treated as ordinary shares. By doing this, that capital would no longer be held under the founder stock QSBS requirements. Therefore, the gains from that fund would be completely free from federal capital gains tax.

Not all accountants, financial advisors, and strategists are convinced that this potential adjustment will work in reality. However, staying prepared, proactive, and up-to-date on proposed legislation and tax code benefits could help protect the startup ecosystem and investors in this ever-changing legal landscape.

Contact us if you have questions about QSBS, Opportunity Zones, and capital gain tax exemptions. 

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

About QSBS Expert

QSBS Expert was founded by a group of entrepreneurs, investors, accountants and lawyers who came together when trying to navigate a QSBS situation of their own. We quickly realized that the regulations left a lot of open questions and the publicly available information was confusing to sift through…so we thought that others may also benefit from having a “go to” resource for all things QSBS.