Financial Planning Strategies to Enhance Qualified Small Business Stock (QSBS) — Planning to Wealth

One planning idea is to structure loss sales over time so that the losses could be used against ordinary income in multiple years. Consider a founder in the 37% tax bracket with $200K of potential losses. If they took those losses in one year, they would benefit $50,700 from saving $100K at 37% and $100K at capital gain rates of 23.8%. On the other hand, if they took $100K of 1244 losses in separate years, they would save $74K.

Other Common QSBS Pitfalls

As founders and shareholders explore strategies to enhance or maximize the benefits of their QSBS, they should be aware of the following potential pitfalls:

• Short positions aren’t allowed on QSBS stock, so post-IPO QSBS holders should generally avoid hedging strategies. A loan against QSBS likely isn’t a short position, but founders should probably discuss possible transactions like this with their tax advisers before proceeding.

• When founders fail to promptly take the 83(b) election within 30 days of issuing their founder shares, it could be detrimental to their financial planning in a few ways. As background, the 83(b) election allows founders to pay taxes on the issuance of their shares before they are even fully vested. Since the value of the company is likely to grow over time, they’ll pay taxes on a valuation amount significantly lower than in the future. Moreover, taking the 83(b) election early starts the holding period clock for QSBS purposes. Thankfully, it’s now common for many law firms to facilitate filing the 83(b) when preparing formation documents, but there are still situations were this important step can fall through the cracks.

• Heirs to a QSBS holder receive a step-up in the cost basis of shares to market value at the time of death, although this new basis is not the basis used for determining the exclusion based on 10X basis. For example, if a founder paid $2 million for their shares and passed away when the shares were worth $7 million, the inherited shares would qualify for a $20 million exclusion (10X $2 million) not a $70 million exclusion.

• Documentation is key for QSBS. It is advised to carefully track the holding period for shares, thoroughly document purchases, gifts, and additional contributions, and consider requesting certification of QSBS status from the company’s CFO. If your startup is using Carta as for cap table management, their QSBS attestation letter service could be helpful for founders, employees, and investors alike. In certain situations it may make sense to get an QSBS opinion letter from a tax attorney.

• Account for QSBS on your taxes correctly – the sale of QSBS goes on Form 1040, Schedule D and the gain exclusion is reported on Form 8949.

• Founders should coordinate with their team to ensure that no business activities compromise the QSBS status. Having too many passive company investments, surplus working capital, or too much non-qualifying real estate can pose risks. Therefore, it is important to analyze the pros and cons, and alternative strategies carefully. 

• Proceed with caution in areas where the rules are unclear. Some would argue that strategies such as incomplete non-grantor trusts (ING) and charitable remainder trusts can bring added tax mitigation. However, it’s possible that there could be challenges at the state level or from the IRS on these structures.

As previously mentioned, we believe this the golden age for QSBS benefits. The current C Corporation tax rate, established by the 2017 Tax Cuts and Jobs Act (TCJA), stands at a historically low 21% and could potentially decrease further depending on future actions by the current administration.

With the number of strategies available for QSBS, we believe founders and shareholders should carefully evaluate their options to potentially maximize this benefit.

FAQs

Does my QSBS holding period start when I receive my SAFE?

SAFE (simple agreement for future equity) terms vary and it can be unclear whether the holding period begins when a SAFE is issued. Most SAFEs include language that parties agree that the SAFE is equity for purposes of Section 1202, but just because parties agree doesn’t mean the IRS would also agree. Many people would argue that since SAFEs are the predominant way of investing in startups and most investors are not given another alternative structure to invest in startups, then they should be considered equity. Others argue that since most SAFE terms don’t include potential dividends and voting rights, then they are more likely considered pre-paid forward contracts than equity.

When does the holding period begin on my company stock options for QSBS purposes?

The holding period for QSBS purposes on a stock option begins when the stock option is exercised. Since there could be tax consequences when executing options, it’s important to balance the QSBS benefits with liquidity needs and other tax considerations.

Do preferred stock and non-voting stock qualify for QSBS?

Assuming all the other qualifications are met, preferred stock and non-voting stock qualify for QSBS.

Is there a way to avoid paying taxes on my gain above the exclusion?

If the gain above the exclusion is rolled over using section 1045 into a new C Corp meeting the QSBS requirements, then those proceeds could qualify for a new QSBS exclusion.

I purchased my shares of a startup from the founder, can I still get QSBS if I hold the shares for 5 years?

Unfortunately not, to qualify for QSBS status, the shares have to be original issuance stock and can’t be received in a secondary transaction. There are some exceptions including shares received from inheritance, gift, or a distribution from a partnership that received original issued stock.

My startup is not a C corp, is it still possible for me to get a QSBS capital gain exclusion?

It still may be possible to get a QSBS exclusion if your company didn’t start out as a C Corp. It’s possible for a LLC or S Corp to convert or restructure their business into a C corp to be eligible for a QSBS exclusion in the future. However, for purposes of meeting the QSBS 5-year holding period, the clock starts on the conversion/restructuring date and not the original formation date of the LLC or S Corp.

With the new tax bill, can I get a partial exclusion if I sell my stock and I’ve held my stock for three years?

Only shares issued after the passage of OBBBA can bet the new partial capital gain exclusion after three (50%) or four years (75%). Shares issued before the passage of OBBBA are not eligible for this benefit.

I have an offer to buy my company as an “asset sale” not a “stock sale”, do I still get an exclusion on the sale proceeds?

The liquidity event has to be a stock sale to receive the benefits of QSBS.

How can I increase my exclusion by “packing” more basis into my startup?

Since the QSBS exclusion is the higher of 10X your tax basis or $10 million (or $15 million for post-OBBBA shares), it may be possible to contribute new funds into your startup and the newly issued shares would have a basis that gives you a higher QSBS exclusion. For example, buying additional shares for $2 million would give you a $20 million exclusion.

What are other ways I can get a larger QSBS exclusion?

Some founders implement QSBS “stacking” to multiply their QSBS exclusion. This involves gifting shares to other individuals or non-grantor trusts, since the recipient of a gift receives a new QSBS exclusion and carries on the holding period of the donor. For example, if a founder gifts shares to a friend, a non-grantor trust for their parents, and a non-grantor trust for their children, then collectively they would have four possible QSBS exclusions instead of one.

If I have both pre-OBBBA and post-OBBBA shares, do I get a $10 million exclusion or $15 million exclusion?

This depends on different factors including the total size of your gain, whether you sell your shares all at the same time, the order in which you sell the shares if the shares are sold in different years, the basis of the shares, and other factors. For example, you could sell both tranches at the same time, then those would likely qualify for a $15 million exclusion. On the other hand, if you sold post-OBBBA for a $10 million gain in one year and then sold pre-OBBBA for another $10 million gain in another year, your total exclusion would likely be $10 million

Are shares issued when aggregate assets were over $50 million and under $75 million now eligible for QSBS? 

Final regulations related to the new QSBS rules under OBBBA have not been released, so we don’t have definitive guidance on situations like this. However, it’s conceivable that a company in this type of situation might be able to qualify for additional R&D expenses decreasing assets below the $50 million threshold by amending previously filed corporate returns. Overall, we think it’s unlikely that pre-OBBBA shares issued between $50 million and $75 million of aggregate assets would now be QSBS eligible.

As an investor in a venture capital fund, will I be eligible for a QSBS exclusion if there’s a liquidity event for a company in the fund?

If you were a fund investor at the time of the investment into the company and at the time of the liquidity event, and other QSBS requirements are met, it’s likely that your portion of the liquidity event is eligible for a QSBS exclusion.

As an investor in a venture capital fund, how will I know which investments are QSBS eligible?

It’s important to have due diligence conversations with the fund managers ahead of a potential investment to understand if QSBS eligibility is a priority in their capital allocation strategy and what sort of QSBS documentation they will provide if there is a liquidity event. For example, if investments are targeted toward smaller companies, domestic C corps, non-service businesses, etc, then it’s more likely that positions will be QSBS eligible.

Can I put QSBS into a family limited partnership (FLP) so that I can use less of my lifetime gift exemption through marketability and minority interest discounts?

Contributing QSBS to a partnership like FLP will make those shares ineligible for the QSBS capital gain exclusion.

Can I use Section 1244 to have my loss offset ordinary income if my startup doesn’t work out?

Yes, up to $100,000 (MFJ) capital losses can be used to offset ordinary income instead of using those losses to offset capital gains and/or ordinary income up to $3,000 per year. Also, the capitalization would have had to be less than $1 million when those shares were issued.