By Eric Little, CPA – 

Money is a common stumbling block for startup businesses. Business leaders need it to hire employees, rent an office and eventually sell their products. But startups, almost by definition, don’t have a lot of extra cash around. That slows their growth—and therefore, their profitability.

Attracting “angel investors” can be tough, which is why startups trying to raise capital should consider offering a little-known but attractive benefit: Qualified small business stock. Under the right circumstances, investors in a small business can cash out their QSBS completely tax-free, even if they had big capital gains. This makes QSBS a fantastic reward for ground-floor investors who stick with a company throughout its climb to success.

How Qualified Small Business Stock Works

Qualified small business stock is stock class issued by a C corporation (not an S corporation or any other business form) from the United States.

As the Internal Revenue Code says, the stock must be original-issue, not resold, which is why this is a great mechanism for early-stage investors. The corporation must not have more than $50 million in assets at the time the stock is issued—also not likely to be a problem for many startups.

During most or all of the time the investor holds the stock, the business must remain a C corporation, and at least 80% of the corporation’s assets must be used in the active conduct of a qualified business*, as defined by the IRS:

  • Every trade or business of such entity is the active conduct of a qualified business within an empowerment zone
  • At least 50 percent of the total gross income of such entity is derived from the active conduct of such business
  • A substantial portion of the use of the tangible property of such entity (whether owned or leased) is within an empowerment zone
  • A substantial portion of the intangible property of such entity is used in the active conduct of any such business
  • A substantial portion of the services performed for such entity by its employees are performed in an empowerment zone
  • At least 35 percent of its employees are residents of an empowerment zone
  • Less than 5 percent of the average of the aggregate unadjusted bases of the property of such entity is attributable to collectibles (as defined in section 408(m)(2)) other than collectibles that are held primarily for sale to customers in the ordinary course of such business
  • Less than 5 percent of the average of the aggregate unadjusted bases of the property of such entity is attributable to nonqualified financial property.

*IRS Qualified Business list courtesy of law.cornell.edu

Deciding what’s a qualified business can get complicated, and we welcome inquiries from business leaders about it, but a technology startup is likely to be a qualifying business. Once all these classifications are met, the real advantage of the QSBS goes to the medium-term holder of the stock.

If the investor holds the stock for at least five years and it goes up in value, the tax code exempts that increase from the capital gains tax!

This is assuming that the investment was made after September 28, 2010, which is likely for current startups.

States may still charge capital gains taxes, so QSBS doesn’t make a windfall from a stock sale completely tax-free. But it does reduce the seller’s tax burden very substantially—and that’s a great enticement for people with money to invest. For startups, incorporating as a C-corporation can be a great way to finance the rapid growth they need to get to market and—eventually—realize a great profit on their ideas.

Talk to our Charlotte CPAs today

Rule updates like the QSBS mean that your financial strategy may shift significantly, to keep up with the best opportunity for your money. Our tax and financial planning professionals at LBJ CPAs have the experience and creativity needed to stay ahead of all tax code changes and to help keep the regulatory burden off our client’s shoulders. Call our office today and schedule your free consultation with LBJ CPAs today to learn more about QSBS and other forms of early startup financing.