In 2015 congress passed legislation, which can put millions of dollars into the hands of anyone who owns qualifying stock in technology and biotechnology companies upon an exit. It presents a tax planning opportunity for founders, investors and shareholder-employees in technology and biotechnology companies. Specifically, stockholders could be eligible for 100% capital gains exclusion upon the disposition of Qualified Small Business Stock (QSBS), which can result in millions of dollars of tax savings on an exit.
The new rules of “QSBS” and how it works
1) What is this
On December 18, 2015, congress passed the Protecting Americans from Tax Hikes (PATH) Act. The bill includes the permanent extension of the Qualified Small Business Stock Gains Exclusion under tax code Section 1202. This legislation encourages equity investments by granting significant tax relief to investors who acquire, and then sell, qualified stock after a specified holding period
2) Why it matters ($)
- Investors : An investor that is issued preferred or common stock in exchange for a $3M investment in QSBS, meets the holding period, and then sells the stock for $30M. You walk away with the entire $30M, instead of footing a $7M tax bill.
- Founders/Employees: A founder/software developer who is granted QSBS at the company’s founding or for services performed, meets the holding period, and then sells the stock for $10M, walks away with the entire $10M, saving $2.5M in taxes. On the other hand, if the same employee was granted options that remained un-exercised until the date the stock sold, all of the gains will be subject to tax.
Equally, a founder or investor that put in $10M initially for their QSBS, met the holding period, and later sold it for $100M, would receive the entire $100M in their hands.
3) Basic Rules
- Typically accessible to startups (value at grant less than $50M)
- Accessible to founders, employees and investors who get stock directly from the company – most tech/life sciences founders will qualify
- Company must be a C-corp
- The stock must be held for at least 5 years
- Must be in a qualifying industry — technology and life sciences qualify (retail, financial services, & real estate holding companies, among others, do not
4) What doesn’t qualify
- Convertible Debt
- Convertible Equity (SAFEs)
- Any stock obtained through a secondary sale (e.g. bought from a shareholder, not from the company)
- Any securities in LLCs
For any security that converts into stock (e.g. convertible debt, options/warrants), the 5-year clock starts only when the stock is issued, not the original security. If an LLC converts into a C-corp, the clock starts upon conversion, not the founding of the LLC.
Also, the recipient must sell their stock in a true stock sale. If the company is sold in an asset sale, the provisions may not apply.
5) What you should do
It’s useful for founders to consider these issues at the time of corporate formation. Specifically, using “pass-through” entities like LLCs may be shortsighted. Considering that forming a C-corporation that is eligible for the 100% capital gains tax exclusion could save millions in taxes upon the sale of the company stock. It may also be a factor that would influence the timing of option/warrant exercise.
Similarly, it is important for investors to be informed about the benefits available to them under as it can significantly affect investment decisions, particularly if it may be more advantageous to pursue an equity transaction rather than a debt transaction.
For more information contact Asael Meir at: firstname.lastname@example.org