Why Section 1202 and QSBS is So Important to Startup Founders, Employees, and Investors
And what the House Ways and Means Committee proposed changes could mean
With the right planning (and by avoiding some potential landmines along the way), holders of Qualified Small Business Stock (QSBS) may be able to avoid paying taxes on up to 100% of gains realized from the sale of stock in a startup. This 100% exclusion has been available to startup founders, employees, and investors since 2010. If the House Ways and Means Committee proposed changes are passed into law, this 100% exclusion would be reduced to 50% for taxpayers with adjusted gross income equal to or exceeding $400,000 for all sales and exchanges made after Sept. 13, 2021 (unless a binding contract to sell the shares was entered into on or before that date). The maximum gain exclusion is the greater of (i) $10 million or (ii) 10 times the holder’s adjusted tax basis in the QSBS. If you are a founder, QSBS should be a factor to consider as you make decisions about forming your company, issuing stock, redeeming stock, and beyond.
First, the disclaimer: Like with most things that lawyers talk about, every situation is different and there are exceptions, details, nuances, and other considerations that are not included in this article. You should always consult with a legal and tax professional to determine if and how you might be able to benefit from QSBS rules.
What is QSBS? Generally speaking, QSBS is stock that (A) is acquired directly (i.e., for cash or in exchange for services) (B) from a “qualified small business” (C) is held for 5 years prior to sale and (D) without a disqualifying event occurring.
What does that all mean?
Acquired Directly. QSBS generally must be originally issued by the company directly to you after Sept. 27, 2010 to be eligible for the full exclusion. In other words, if you bought your stock directly from the company and after that date, that’s good. If you bought it from another stockholder, you will likely not be able to benefit from Section 1202. There are exceptions for certain transfers by gift, death, certain tax-free reorganizations, or, in limited circumstances, to or from a pass-through entity, so proper tax and estate planning can preserve QSBS treatment even after certain transfers. If you receive restricted stock as a startup employee, that stock may also qualify, provided that you make an 83(b) election or, in lieu of an 83(b) election, the restricted stock fully vests.
A “Qualified Small Business.” This refers to a (1) United States C-corporation (2) engaged in a qualified trade or business (3) with aggregate gross assets no greater than $50 million prior to the issuance.
So equity issued by foreign companies, S-corporations, and LLCs cannot qualify as QSBS. However — and this is a big “however” — it is possible to convert an LLC or other non-qualified company into a C-corporation in a way that exchanges non-qualified equity for newly issued QSBS. If that happens in a non tax-deferred manner and at a time when the value of the non-qualified equity is high enough so that the basis of the newly issued QSBS exceeds $1 million, then the QSBS gain exclusion may even exceed the typical $10 million maximum (since the exclusion will instead be capped at the larger 10x basis). As a note, conversions from S-corporations in particular should be given extra attention, as they are unlikely to qualify the stock as QSBS absent a corporate restructuring or other targeted planning. This issue often isn’t discovered until diligence in connection with an exit, when it is far too late to make the exchange and start the 5-year holding period discussed below.
The definition of qualified trade or business is fairly broad and essentially requires operation outside of a few proscribed industries. Most early stage technology companies will qualify even if tangentially related to some of the more common exclusions (such as the hospitality industry, personal services, the financial sector, farming, and mining). So, for example, companies engaged directly in the performance of services in health or financial services generally do not qualify, but many healthtech and FinTech companies do as a software as a service business model is typically viewed as distinct and separate from the underlying field of service. Eighty percent of the corporation’s assets must be used in the active conduct of a qualified trade or business for the duration of the taxpayer’s holding period. This is highly fact-specific, and there are strategies for companies to implement to the extent they are engaged in both qualified and non-qualified trades or businesses.
To issue QSBS, the company must also have remained under $50 million aggregate gross assets at all times prior to the qualifying issuance. Previously issued QSBS does not lose its eligibility when this threshold is crossed, but the company can no longer issue new shares of QSBS, even if the total subsequently drops below that number.
Held For 5 Years Prior to Sale. A holder must have held the stock for a 5-year period prior to the date of the sale in order for the stock to qualify as QSBS. Filing an 83(b) election will generally start the clock for restricted stock issued for services. Similar limited exceptions to the original issuance requirement above generally apply here in the event of transfers, but, as with that requirement, affiliate transfers should be reviewed for 1202 compliance to ensure the 5-year holding period will carry over to the transferee as intended. Certain rollover transactions may preserve QSBS treatment for stock that is sold prior to being held for 5 years.
No Disqualifying Event. Certain actions taken by the company can affect QSBS treatment for a single holder or for a group of (or all) stockholders at once. In addition to the failure to maintain a qualifying trade or business as described above, redemption and tender offer transactions (which have become increasingly common for fast growing startups) present a minefield of issues that can destroy the opportunity to benefit from Section 1202. For example, during the 2-year window on either side of a stock issuance to a particular holder, a redemption of any stock of such holder will void QSBS benefits as to that stock issuance. In addition, certain larger stock redemptions occurring during a 1-year window on either side of a stock issuance can destroy QSBS eligibility for all stock issued in that issuance. Because of these rules, any proposed redemption transaction should be discussed with counsel as early in the process as possible.
As mentioned above, this article does not address every detail, rule, or exception out there that may help — or hurt — QSBS eligibility.
 QSBS issued after Sept. 27, 2010 is eligible for the 100% exclusion, and QSBS issued after Aug. 10, 1993 and before Sept. 27, 2010 is eligible for a 75% exclusion. If the House Ways and Means Committee proposed changes are passed into law, both the 100% and 75% exclusions would be reduced to 50% for taxpayers with adjusted gross income equal to or exceeding $400,000 (subject to the binding contract exception).