The Section 1202 exclusion for qualified small business stocks (QSBS) can provide significant tax savings for investors in small businesses. It allows investors to exclude up to 100% of the gain from the sale of QSBS from taxable income, provided certain conditions are met. Despite the huge potential savings this tool provides, it’s often misunderstood. For startup company founders and investors, understanding Section 1202 can make a massive difference on your return on investment.
Founder stock
Myth: “I am a founder, and I got my stock on day one, so my stock has to be QSBS! Of course, we all had vesting requirements.”
It’s common for founder’s stock to be subject to vesting or other restrictions (restricted stock). This might include requirements for founders to stick around for a period of time, requirements to buy out founder stock at a particular price if they leave, or other similar events. Some of these terms may be very formal and others may be informal. Some may even be built into sample documents used by the founders to create the company even if they didn’t really intend them to be there. But any of these terms have the potential to adversely impact the QSBS classification or reduce the overall benefit without proper planning on day one.
The Section 1202 analysis for restricted stock begins when the stock vests, but that determination can be complicated depending on the nature of the restrictions that might have been put in place on the founders. For example, you determine at each vesting date whether the company’s assets are less than $50 million. If the company later becomes too large to issue QSBS as of later vesting dates, that block of stock won’t qualify. The five-year holding period also begins at each vesting date.
Making a Section 83(b) election for your stock can allow you to start the five-year holding period and lock in QSBS status while the company is still below the $50 million asset test. However, the accelerated vesting also may accelerate tax on the stock grant. Shareholders should weigh the benefits and costs of the election — but do so quickly, because the election must be filed with the IRS within 30 days of the stock issuance.
Myth: “I’m not sure I have a stock certificate, but I’m one of the founders. Everybody knows my stock was issued more than five years ago, so I can still qualify.”
Maintaining complete and thorough documentation is very important. Startups that don’t maintain comprehensive records aren’t barred from the benefits of Section 1202, but they may face challenges that can otherwise be avoided. This is particularly true when it looks like stock ownership has changed over time, maybe in response to founders leaving the company or roles changing, but precisely how the ownership change was effectuated is unclear. Important documents to maintain include: articles of incorporation, stock issuances (including original issuance certificates), contribution agreements, stock redemptions, shareholder agreements, balance sheets, employment agreements, Section 83(b) elections, etc. Poor recordkeeping can significantly complicate the process of demonstrating original issuance and other requirements. When companies are just starting out, they might lack the resources to thoroughly document significant events, but if QSBS is a goal, then it’s crucial to ensure your documentation accurately reflects the actual events.
Nonfounding investors
Myth: “I was not a founder of this business, so my stock will not qualify.”
While it’s true that founders often qualify for Section 1202, shareholders aren’t required to be a founder or participate in the first rounds of funding to benefit from the Section 1202 gain exclusion. As long as the company still meets the requirements at the time of issuance, such as the $50 million asset requirement, any stock issuance has the potential to qualify.
But, it’s important to note that the stock does have to be issued directly to you by the corporation. Your stock will only qualify if you’re the first investor to hold the stock. If stock is purchased from a founder or another investor, it won’t qualify as QSBS for the purchaser. There are a limited number of exceptions for transfers, including by gift, death, distribution out of a partnership, and certain tax-free exchanges.
Age and size of business
Myth: “Our business has been around for a while, and let’s just say we aren’t small anymore. We might have qualified for Section 1202 treatment once, but we’re too big for my stock to qualify anymore.”
Fortunately, the determination of whether the company meets the $50 million asset threshold is made when the stock is issued, not when it’s sold. The $50 million determination is also generally made based on the tax basis of the assets not the fair market value or even book value — so often businesses can qualify much longer than you’d think! If a company issues stock before it ever had more than $50 million in tax basis in its assets, that stock can still qualify for the Section 1202 gain exclusion regardless of the size of the company when the stock is sold.
Stock options and convertible debt
Myth: “I have stock options that I have held for over five years. That means my options qualify for Section 1202 treatment.”
The five-year holding period only begins when a shareholder holds actual stock — so stock options and convertible debt don’t start the QSBS holding period until they’re exercised or converted. If you hold options in a company that qualifies for Section 1202 treatment, consider exercising the stock to both start the five-year clock and receive the stock before the company becomes too large to qualify. While the exercise might create a tax liability today, it might still be the more advantageous tax strategy over the long run.
Section 1202 companies must be C Corporations, but…
Myth: “We’re a partnership, so we’re locked out from Section 1202.”
While Section 1202 does require the business to be taxed as a C corporation, partnerships may be able to restructure into a C corporation to qualify for this exclusion. In fact, sometimes you might save more money by starting as a partnership and converting to a C corporation as the company begins to grow. We’ve previously examined the optimal time to incorporate your flow-through entity, including balancing the growth of the company to maximize gain exclusion with limiting tax on existing gain.
Myth: “My company is an S corporation. I’ll just revoke my S election to get into Section 1202.”
A corporation must have been a C corporation at the time stock is issued in order for those shareholders to qualify for Section 1202. However, an S corporation isn’t entirely out of luck because it may be able to restructure its business into a newly formed C corporation that’s a subsidiary of the S corporation and take advantage of Section 1202. This is a relatively common technique for businesses that weren’t thinking about Section 1202 upon formation.
Contributing stock to a partnership
Myth: “I contributed my QSBS into a family partnership as part of my estate planning so now my entire family can take advantage of the gain exclusion as well.”
Contributing property to a partnership is typically a tax-free event and common part of estate planning. However, stock contributed into a partnership will immediately lose its QSBS status no matter who the owners of that partnership are. If you’re looking for an opportunity to transfer shares to family and friends, it may be better to gift it directly or consider the use of certain types of trusts.
Can you own your qualified stock through an S corporation or partnership? Certainly! But, there are some additional requirements for your gain to be qualified. First, you must be an owner in the pass-through when the pass-through is issued the stock by the corporation. On exit, the pass-through entity must directly sell the stock for your share of gain to qualify. Selling the pass-through entity won’t be eligible for gain exclusion, even if the qualified stock is the only asset of the pass-through entity.
R&D and startup activities
Myth: “My business is still in the startup phase and is pre-revenue. Since we’re only involved in R&D, I don’t think we’re a qualified business.”
While Section 1202 does require that the company is actively involved in a qualified business, fortunately, startup and R&D activities will meet this requirement if they’re in connection with an anticipated future qualified business. However, the future business that you’re working toward does need to be a qualified business, which excludes a number of businesses like consulting, health, certain professional services, finance, hotels, restaurants, and more.
As an additional benefit for early-stage companies, there are also relaxed rules for carrying cash or other working capital assets on the balance sheet without disqualifying your stock, particularly for the first two years of existence. This can be particularly useful for startups that have large capital needs early on even if they won’t spend all of the cash immediately.
Expansion into new service lines
Myth: “My startup has pivoted its focus to respond to market conditions, but that won’t change my eligibility for QSBS treatment.”
As your business grows and explores new services lines or pivots its focus, engaging in nonqualified activity, such as consulting or finance, could disqualify your stock from the benefits of Section 1202. This determination is not all or nothing, and early identification of nonqualifying activities combined with proactive structuring can help to protect your Section 1202 qualification without impacting the path that will make the business most successful.
Redemptions: The good, the bad, the ugly
Myth: “I know that redemptions of stock can cause QSBS problems, but none of my stock was ever redeemed so I’m ok.”
The redemption of stock often is treated for tax as a sale or exchange, allowing the exiting shareholder to obtain QSBS treatment if the redeemed stock has been held for at least five years and all other requirements have been met. So the good news is that a redeemed shareholder might still qualify for gain exclusion!
If the redemption is “significant,” it can disqualify the QSBS treatment of any other stock issued within a year (before or after) the redemption. The redemption can also adversely impact the investor, by disqualifying stock issued to that investor or related shareholders within two years. There can be exceptions, such as when the shareholder is redeemed due to death, disability, or termination of employment, but even these exceptions have restrictions.
This can be a really damaging trap when founders exit a startup early in its life. It may also post problems if a founder is taking money off the table in connection with a funding round because it can become complicated to ensure that the new investors receive QSBS treatment. To avoid this trap for the unwary, a company should carefully evaluate the QSBS impacts of any buyback of shares before executing.
What to do now?
Myth: “My friend told me that my startup qualifies as QSBS, so I don’t have to talk to my accountant about it until after I have a liquidity event.”
You don’t necessarily need an accountant or an attorney to validate QSBS treatment upfront. There is no election, statement, or other filing with the IRS that’s necessary to perfect QSBS treatment. But, beware of a lot of potential traps, and approaching QSBS treatment casually can end up causing millions of dollars of additional tax to be due on a final liquidity event in the future.
Whether you’re just starting a company, holding stock in a growing business, investing in an existing business, or getting ready to exit, we’re here to help guide you through the process to maximize your QSBS benefits and minimize your tax liability.
