Let’s get technical for just a minute and talk about how companies can help their investors save on taxes. In the process, companies can create a more appealing and attractive opportunity to bring those investors in.
The little-known tax benefits on Qualified Small Business Stock (QSBS) are adding more appeal for investments in tech startups. With Regulation A offerings in particular gaining momentum, the tax benefits of this type of stock are now available to everyday investors looking to support the early-stage tech companies they believe in. Regulation A investors do not need to be accredited, and minimum investment costs are usually low, which greatly reduces the barrier to entry. For those not familiar with QSBS, knowing the background, what qualifies you to take advantage and the benefits are key.
Brushing Up on the Basics
If you’ve never heard of the term, you may be asking yourself what exactly is Qualified Small Business Stock (QSBS). Put simply, the term refers to shares of a qualified small business, which is an active, domestic C corporation whose gross assets don’t exceed $50 million before or immediately after it issues stock. Qualified small businesses generally include firms in sectors like tech, retail and manufacturing, but not those like hospitality, professional services, finance and agriculture. For investors in the private market looking to build a portfolio of budding tech startups, this is where the benefits of QSBS come in.
Under Section 1202, capital gains from QSBS are partly or wholly exempt from federal taxes and holders of QSBS may be able to exclude between 50 percent to 100 percent of the gain on the sale of their QSBS, provided they meet certain criteria. There is also a cap that applies per shareholder equal to the greater of $10 million cumulative or 10 times the adjusted basis of QSBS sold during the year. The level of tax benefits will, of course, vary from investor to investor and depend on when the stock was acquired and how long it has been held.
How to Make Sure You Qualify
To ensure you’ll be eligible to claim these tax benefits, investors need to meet a few criteria:
- You cannot be a corporation
- You must have acquired the stock at its original issue
- You must have purchased the stock with cash, property or accepted it as payment
- You must have held the stock for at least five years.
- At least 80 percent of the issuing corporation’s assets must be used in the operations of one or more of its qualified trades or businesses
As with all tax benefits, it’s important to speak to your trusted tax advisor to ensure that you and any potential investments meet all qualifications, as there are various applications and exceptions. For example, if your exit is under the five-year minimum window, you can still qualify if you roll your investment into another qualified small business. This is referred to as 1045 rollover. This process allows you to still maintain QSBS eligibility provided the aggregate holding period meets the five-year minimum. Despite the change in investment, you can be treated as if you held one investment for a five-year term and thus retain the QSBS exemption.
Breaking Down the Benefits
The possibility to exclude 100 percent of the gain on the sale of stock is virtually unmatched, and yet many people are not aware of this benefit from Section 1202. Since the 1990s, there has been a series of increases to this potential exclusion, and even with those increases, this benefit went largely unused for years, likely due to lack of awareness. The original 50 percent exclusion was upped to 75 percent for those acquired between February 18, 2009 and September 27, 2010, and then again to 100 percent exclusion for those acquired on or after September 28, 2010. As an added bonus, and unlike many other tax breaks, this 100 percent exclusion is permanent.
Shrewd investors should be on the lookout for QSBS offerings and see if they can be eligible to take advantage of this excellent opportunity provided by Section 1202. The overall takeaway is that there are often ways that nontraditional investments can provide additional value. For example, Regulation A offerings in sectors like tech are growing in popularity and many of them qualify as QSBS, and therefore their qualifying investors can take advantage of the subsequent tax benefits. These QSBS tax benefits are particularly attractive now as Biden’s proposed tax plan aims to increase the capital gains taxes. While more typical bread-and-butter investments are great, it’s absolutely worth keeping your eye out for these nontraditional investing opportunities that support small businesses.
Steven Weinstein is the CEO of Seismic Capital Company, an early-stage growth investor committed to identifying, guiding and nurturing companies seeking to meaningfully disrupt the space they work in. Weinstein has been involved in the capital markets, financing, private equity, venture capital and real estate over the past 30 years. Since 2002, he has been the managing director of Marketmaker Capital where he managed numerous transactions, capital structures and projects ranging from real estate advisory, loan portfolio structures and private equity funding.
James Warren is a partner in Potomac Law Group’s tax practice group. Formerly a banker in London, New York and Germany, Warren has focused his legal practice on federal income tax matters, international restructurings and cross-border transactions. He has lengthy experience handling tax controversies, having represented Freddie Mac for many years in a series of reported cases in the U.S. Tax Court and advising clients on domestic and international tax planning and compliance.