“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Section 1202 of the Internal Revenue code, originally enacted in the early 1990s, states: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.
If I have a convertible note with warrant coverage purchased in 2010, but converted to a VC A round in 2014, what is the date for QSBS tax rules?
Following the previous post, same question for paper purchased in 2011 to 2013?
Phil – Does this apply to founders’ stock where the founders didn’t make a cash investment, thus have a cost basis of zero? If no, can the founders get around that by writing small initial capitalization checks?
Unfortunately, California no longer allows the QSBS exclusion on state taxes, as a result of the courts striking down the statute in Cutler vs. FTB. Talk about collateral damage. See https://www.ftb.ca.gov/law/Qualified_Small_Business_Stock_and_Cutler_Decision.shtml
Thank you for the article, but investors should also remember the interplay of the Federal alternative minimum tax on the excluded gain. For much of the time that the QSBS exclusion has been in effect, the excluded gain has constituted a tax preference item, thus vitiating much of the tax benefit. Importantly, note that gains generated from investments during 2011 to 2013 (when the exclusion percentage was 100%) will not be treated as preference items and are thus truly Federal tax-free.
Phil – thanks for highlighting the benefits of the QSBS exclusion. It’s a very important tax planning tool for entrepreneurs and early stage investors. That said, I wanted to highlight a couple of important corrections:
1. California – as of 1/1/13, there is no state QSBS exclusion or deferral in California. At the end of 2012 (as a result of a lawsuit over the state-specific requirements of the California version of QSBS) FTB cancelled the CA QSBS and tried to retroactively implement that cancellation back to 2008. Working with a group of affected entrepreneurs, we got new legislation introduced and passed (AB1412) which overturned the retroactive application of this cancellation and saved entrepreneurs and investors an estimated $120M in extra unplanned taxes. The unfortunate casualty of this process, however, was that we couldn’t convince legislators to re-implement a going-forward QSBS tax exclusion. Therefore, starting 1/1/13, there simply isn’t one in California. We hope that legislators will take up the issue to reinstate a California QSBS for 1/1/13 onward, but as of now if you were to sell your small business stock, be subject to CA taxes, and otherwise qualify for QSBS treatment, you’re simply out of luck. You’ll be paying the full tax (now potentially higher due to Prop 30). You mentioned selling some of your Pandora stock in 2013 and paying half the rate. I’d urge you to check on that with your CPA as there simply isn’t a way to do that (it’s not even an option in the 2012 or 2013 tax forms),
2. Federal – the original 50% federal QSBS law and the amendment that reduced the exclusion from 50% down to 75% for 2009 and 2010 acquisitions are still subject to AMT. This has a net effect of raising the actual cash paid to the IRS significantly. While 75% of the 28% rate should be 7% in net taxes on the sale, the reality for most eligible taxpayers will likely fall in the 11-12% range. No doubt this is still a great deal for those taxpayers, but not the 7% suggested by the simple reading of the law. The further amendment that dropped the rate to a 100% exclusion included an important note that removed AMT consideration from the QSBS calculation. That means that for those who acquired their stock in that eligible time period, it is a true 100% federal exclusion – assuming that the taxpayer and the issuing company meet all of the other requirements to take the QSBS.
It’s unfortunate that more entrepreneurs and investors aren’t aware of these potential benefits and especially scary how few CPAs are well versed in them.
Again, thanks for brining this issue to light.