As a founder of a startup, you’re putting your belief in a delayed gratification model. Those early days of building your company will probably be lean. You’ll work nights and weekends in exchange for what’s most likely a small amount of pay.
The thinking goes that you’ll see significant ROI on this effort. Down the road, the shares you have in your company will ideally be worth a sizable sum. And when you sell them, you’ll get a payout that reflects all your years of hard work.
Of course, taxes are often the rain over many profit realization parades. But if you do things right — that is, in accordance with a certain section of the Internal Revenue Code (IRC) — you can seriously limit the size of the tax hit you take.
With that in mind, let’s look at what founders need to know about Section 1202, qualifying small business stock (QSBS), and their taxes.
The basics of QSBS tax benefits
Section 1202 of the IRC — the “Partial Exclusion for Gain from Certain Small Business Stock” — allows you to protect millions of dollars of profit from selling shares from capital gains taxes.
As with much of the IRC, you have to meet certain criteria to qualify for this exemption, and the stock you sell does, too. For starters, the capital gains tax protection only applies to QSBS that’s tied to a domestic C-corp (sorry, founders of S-corps and other entity types) and sold by an individual (sorry, venture capital firms).
Note the “small business” part of QSBS, too. To meet the applicable criteria here, your business can’t have gross assets that exceed $50 million immediately before or after issuing that stock.
Assuming your company does issue qualified small business stock, Section 1202 gives the individual selling the stock (read: you) the ability to exclude up to $10 million of it from capital gains taxes.
In other words, the profit you make up to $10 million could be taxed as income, not capital gains. That means you can sell right away at that lower tax rate rather than waiting a year for that stock to cross into long-term gains.
Exclusions to QSBS
Unfortunately, some businesses’ stock can never qualify for QSBS tax treatment, even if they’re domestic C-corps that meet the other qualifying criteria. Per § 1202(e)(3), shares aren’t ever considered QSBS for:
- Banking, financing, insurance, investing, or leasing companies or others in a similar vertical
- Farming operations
- Mine, natural deposit, and well extraction and production companies
- Hospitality businesses like hotels, motels and restaurants
You’re also excluded from QSBS tax treatment if your business offers a service that depends on your skills or reputation or the skills/reputation of any of your staff. Lawyers and architects often find themselves excluded under this portion of Section 1202, for example.
Learning more about Section 1202
This is a fairly brief overview of this section of the IRC and its implications for founders (and angel investors). If you want to do a deeper dive into what’s required to have shares qualify and how to sell them to maximize the tax benefit here, our QSBS guide can help.
If you’re not sure if your business or its stock can qualify, talk with our team. We can help you sort it out.
Secondary transactions and QSBS
As the founder of a startup, you’ve probably had your fair share of years of managing your life with less-than-ideal take-home pay. Since you’ve probably also been logging extra hours, that limited pay can take its toll. After such long days and working weekends, it sure would be nice to come back to a home you love, or to be able to take that vacation you’ve been picturing.
Some investors get it. And they might consequently offer secondary transactions.
In this situation, the investor buys some of your shares (usually a nominal amount) in exchange for some liquidity (e.g., $1 million). You usually won’t get this type of offer from an investor until Series B or later.
There’s a chance that this transaction can qualify under Section 1202, allowing you to take that pay without it getting taxed as capital gains. But it needs to be carefully structured to be compliant.
The IRS often views secondary transactions as bonuses rather than as the purchase of stock. As a result, it’s important to work closely with your accountant to ensure all of the facts and circumstances around this transaction give you the best shot at qualifying for QSBS tax treatment.
If an investor approaches you with a secondary transaction offer, loop your accountant in early. Doing so can help you pocket a much bigger chunk of that money.
An advanced tax planning measure: QSBS stacking
As we mentioned before, QSBS is eligible for up to a $10 million exemption from capital gains tax for the individual taxpayer. But there’s a way to extend that exemption even further.
Some founders and angel investors have started to leverage a practice called QSBS stacking. This means establishing multiple trusts, each owning a portion of their shares. Assuming this is all structured properly, each of those trusts is entitled to the $10 million exemption.
So if, for example, you establish three trusts and distribute your shares across them, you could potentially protect $40 million (your $10 million, plus $10 million from each of the trusts) from capital gains taxes.
QSBS stacking is perfectly legal, but it does require some fairly sophisticated maneuvering to ensure that the IRS sees shares as qualifying small business stock, and to ensure the trusts meet the qualification criteria under Section 1202. For help meeting the requirements to get the best tax treatment with QSBS stacking, talk with your accountant and attorney.
If you’re still on the hunt for an accountant who has expertise in areas like Section 1202 qualification, QSBS stacking, and otherwise optimizing the pay you take home as a founder, we’re here. We have extensive experience supporting tech startups in building the bookkeeping and accounting processes they need to succeed. And we never forget that the founder deserves regular payouts, too.
To explore working with our team, contact us today.