Even with capital markets in a state of decline, capital continues to flow into venture capital.
Pitchbook data indicates that U.S.-based VCs have $290B in dry powder and have raised a record amount in the first quarter of 2022.
Aside from the potential for outside returns (e.g., Figma), VCs (and founders) also have the potential for significant tax breaks on gains.
Perhaps the most significant tax break for noncorporate founders and funders is qualified small business stock (“QSBS”), which excludes income from gains recognized on the sale of qualified stock held for more than five years.
Generally, under Section 1202 of the Internal Revenue Code, holders of QSBS can exclude from their income the greater of:
- $10 million; or
- 10 times the aggregate adjusted bases of QSBS issued by the corporation and disposed of by the taxpayer during the taxable year.
How does stock qualify as QSBS?
To qualify as QSBS, the following criteria must be met:
First, the Company must be a domestic C-Corp. This is one of the main reasons that VCs will require founders to incorporate as Delaware C-Corps (as opposed to LLCs) before investing. LLCs can convert to C-Corps begins at the time of conversion.
The Company’s assets must be $50 million or less on the date at the time of and immediately after the issuance.
This requirement could be potentially problematic if the Company’s fundraising activities push its assets over the $50M threshold.
The Company must be engaged in a qualified business such as technology, retail, wholesale, and manufacturing.
Additionally, the stock must be acquired in exchange for money, property, or as payment for services provided to the Company, as an original issuance (e.g., not acquired on the secondary market).
This should not be much of an issue as the most common situations include stock sold to investors or granted to founders, employees, and advisors.
Companies use QSBS to incentivize investors to purchase stock and motivate employees to invest in the Company they help build.
What about employee stock options?
Companies commonly use stock options to compensate and incentivize employees.
If an employee acquires stock by exercising a stock option, the holding period only begins on the exercise date and not on the grant date (i.e., the date the stock options were granted).
This incentivizes employees (and other service providers) to exercise their stock options early to trigger the 5-year holding period.
What happens if a stockholder sells her shares of QSBS before holding for five years?
If a stockholder sells QSBS before satisfying the five-year holding period, they will not receive the generous QSBS tax exemption and will be taxed at the normal capital gains rate.
Thus, it behooves investors to hold on to their qualified small business stock and not sell until the five-year holding period has passed.
What about the fine print?
Even if stock qualifies as QSBS, it may be disqualified if the Company engages in certain redemption transactions (i.e., the Company repurchases stock).
Now, let’s take a look at how this works in practice
Imagine the year is 2023, and you invest $100,000 in a start-up company called Mind Bloggling, Inc., which reads Junto’s blogs aloud and automatically stores the information in your brain. Brilliant, I know.
Suppose, after 5-years, Mind Bloggling has taken the market by storm and is acquired for $15 million!
Well, if the shares in Mind Bloggling qualified as QSBS under Sec. 1202 you’d pocket the $14.9M in gains and be able to exclude $10M in gains from your income.
Conclusion
The QSBS tax exclusion is a win-win benefit to both stock-issuers and stockholders.
Corporations can leverage the QSBS tax benefit to attract more capital while investors, founders, employees, and advisors can capitalize on more profits.
About the Authors
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Disclaimer
While Junto is a law firm that enjoys operating outside the traditional lawyer and law firm “box,” we are not your lawyers. Nothing in this post should be construed as legal advice, nor does it create an attorney-client relationship. The material published above is intended for informational, educational, and entertainment purposes only. Please seek the advice of counsel, and do not apply any of the generalized material above to your individual facts or circumstances without speaking to an attorney.
