“Nowadays it’s six figures when they tax me.”
– Drake, “Over My Dead Body“
What is Qualified Small Business Stock (QSBS)
For 17 years as a VC, I have written over 50 term sheets and all have contained a clause with the term “QSBS.” If you don’t know what it means, you should, since it can save you hundreds of thousands of dollars in taxes. QSBS stands for Qualified Small Business Stock and is defined in the Internal Revenue Code Section 1202. Just as the Federal and State governments incent investors to hold investments for over a year with a reduced long-term capital gains rate, they provide additional incentives to hold investments in startups for over five years.
Section 1202 of the Internal Revenue code, originally enacted in the early 1990s, states:
The term “qualified small business” means any domestic corporation which is a C corporation if the aggregate gross assets of such corporation … does not exceed $50,000,000…In the case of a taxpayer other than a corporation, gross income shall not include 50 percent of any gain from the sale or exchange of qualified small business stock held for more than 5 years.”
However, your savings is limited to the greater of $10M of gains in a taxable year or 10 times the aggregate adjusted bases of QSBS.
My QSBS Lesson on Pandora
I was fortunate enough to invest in the first institutional round of Pandora in 2004 (while at a previous venture firm) valued at $8M (today the market cap of Pandora is over $6B). When I wrote the term sheet, I included the following clause:
The Company will represent and warrant to Investors that it qualifies as a ‘Qualified Small Business’ as defined in Section 1202(d) of the Internal Revenue Code…
Fast forward to October 15 of 2013, and I had a high-quality problem that related to QSBS for the first time. It was time to pay taxes on my Pandora stock sales. My accountant at the time, who is no longer in my employ for this very reason, did not point out the QSBS detail. But I did research and determined that my stock sales and cash distributions of stock sales from my prior venture fund were eligible for a reduced tax rate, since the stock was defined as QSBS. As a result, I paid only half of the California tax rates (6.6% instead of 13.3%) in 2012 and 2013 and 14% federally in 2012 and 2013 (instead of (15% and 20% respectively). I was also able to pay far less tax and receive a large refund on my overpaid withholding tax for 2013 stock sales, as well. There is no way the Federal and California State governments would have known if I sold QSBS stock unless I declared it, so I would have overpaid with no chance for a surprise refund from the government.
This is especially relevant as of January 1st of this year since the long-term capital gains rate increased from 15% to 20%. The way it works is that 50% of QSBS stock is not taxed and the remainder is taxed at the long-term capital gains rate of 28% (this was the tax rate when section 1202 of the tax code was passed in 1993). Therefore, QSBS stock would only drop your tax rate from 15% to 14%. As of 2014, it drops your Federal tax rate from 20% to 14%.
But Wait, There’s More…
As part of recent legislative efforts to stimulate the economy, the Federal government increased the benefits of QSBS. If you purchases QSBS stock in 2009 and 2010 and hold it for 5 years, you only pay 25% of the Federal long-term capital gain taxes; and if you purchased QSBS stock in 2011, 2012 or 2013 and hold it for 5 years, you don’t pay any Federal long-term capital gain taxes. BTW, most states, including California, have a 50% deduction off the long-term capital gains rate, as well.
In addition, if you own QSBS stock and sell it before 5 years, you can defer the tax on potential gains by transferring the basis from the first stock to the second if you purchase QSBS stock in another company within 60 days.
According to the IRS, if you are a VC, angel investor, or own stock options:
The stock must have been acquired in exchange for money, property (except stock), or services (except services as an underwriter of the stock). The stock may be acquired through the exercise of an option or warrant, or the conversion of convertible debt.
I spoke with a Big Four accounting firm that specializes in working with startups and VCs, who confirmed that VCs, angel investors, and stock option owners remain largely ignorant of QSBS.
“QSBS stock is one of the most misunderstood parts of buying and selling stock that we see among Entrepreneurs and VCs in the Valley.”
Save yourself money and talk to your tax advisor today about QSBS.