How Founders Can Pay Zero Taxes On Up To $10 Million

The original article was published in Forbes on Jan 23, 2020 - How Founders Can Pay Zero Taxes On Up to $10 Million

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Qualified Small Business Stock (QSBS) is a tax provision that allows founders and investors of early-stage companies to exclude $10 million or more from their taxable income, but few have heard of it. Here's why it can make a big difference—and what you need to know about it.

QSBS, a part of Section 1202 of the Internal Revenue Code, was signed into law in 1993 with the intent to create jobs and stimulate technological innovation in emerging industries. This tax exclusion allows founders and investors to potentially pay zero federal income tax on up to $10 million or 10x on an investment if the five conditions below are met. Many states (unfortunately excluding California) have adopted analogous provisions allowing the same tax savings on the state level as well. As a founder or investor, the most important step to avail yourself of this aggressive tax incentive is knowing that it exists and making sure your tax professional is aware of it.  

Even if you were unaware of this provision when you sold your company, it might not be too late. You can potentially amend your tax returns for up to three years to take advantage of a qualifying QSBS exclusion you initially missed out on.

How do you qualify?

Here are the five conditions:

1. You have held the stock for at least five years (take note of the “1045 Rollover” section below if you fall short of the five-year window. There is still hope);
2. The stock was issued by a C corporation, with assets valued under $50 million when the stock was issued;
3. The company must be in a business that makes something—80 percent of the corporation’s assets must be used in the course of a qualifying trade or business—service businesses, real estate, and farming, etc do not qualify;
4. You are a US non-corporate taxpayer who acquired the stock directly from the company (Secondary shares do not qualify and hedging transactions may disqualify the QSBS); and
5. The stock was issued after Sept. 27, 2010. Lesser exclusions are available for stock issued prior to 2010.  

How much can you save?

The QSBS exemption eliminates federal income tax on capital gains and also eliminates the 3.8% Medicare surtax. Thus, you can save up to $2.38 million on a gain of $10 million (assuming a capital gains tax rate of 20% and the 3.8% Medicare tax). Many states - though not California - have adopted analogous provisions allowing the same tax savings on the state level as well.