When Jon Hainstock sold his SaaS company ZoomShift in January 2020, he and his co-founder saved hundreds of thousands of dollars in capital gains taxes because of how they structured the company and the deal.
By selling ZoomShift through qualified small business stock (QSBS), Haintock was able to take advantage of an exemption in the tax code designed to save founders like him money.
“[QSBS is] an important thing to consider if you’re starting something new,” Hainstock told They Got Acquired founder Alexis Grant in a podcast interview. “If you think you might be able to get to an exit like that, QSBS could end up saving you a lot of money.”
What we’ll cover in this story:
- What is QSBS?
- QSBS requirements (to figure out if you qualify)
- QSBS holding period
- QSBS tax rate
- When a QSBS sale makes sense for your business
- Why some buyers don’t like C corps
- QSBS checklist: preparing for a future sale
What is QSBS?
QSBS stands for qualified small business stock, a share of a company that comes with federal tax benefits. Under the Internal Revenue Code — U.S. tax law — sales of shares in qualified businesses are exempt from capital gains taxes. Those can be significant, up to 20% in 2021.
Section 1202 of the tax code carves out the QSBS exemption, defining a qualified business as a domestic C corporation with $50 million or less in assets.
In short? The QSBS exemption is a way for certain small business owners, employees and investors to sell all or part of a business with potentially massive tax savings.
“Many founders are either unaware or not utilizing the benefits of QSBS and are missing out on potential savings with this tax code,” Ezra Gardner, a partner at the investment firm Varana Capital, LLC, said.
Normally, if you sell shares of your business, you owe tax on the gains. If you sell within a year of acquiring the shares, you pay your income tax rate. After a year, you pay the capital gains tax rate, which is up to 23.8% depending on your income.
But if those shares are QSBS stock, at least part of your gains are exempt from federal taxes. They’re also exempt from state income or capital gains taxes in most states, excluding Alabama, California, Mississippi, New Jersey, Pennsylvania, Puerto Rico, and partly exempt in Massachusetts and Hawaii, according to CapGains, which makes tax optimization software.
QSBS requirements: Do you qualify?
To qualify for QSBS tax treatment, both you — the stock owner — and the business have to meet certain criteria.
The business must:
- Be a U.S.-based C corporation, as recognized by the IRS.
- Have $50 million or less in assets.
- Be an active business — at least 80% of its assets are being used to conduct business. (Passive activities such as investing can’t make up more than 20%)
- Not be in an excluded industry, which Shauna A. Wekherlien, CPA and founder of the Tax Goddess accounting firm said includes, “typically personal services, such as banking, financing, insurance, investing, leasing, etc.”
Eligible stock owners must:
- Hold the stock for at least five years.
- Be an individual, not a corporation. (i.e. You can’t have bought the stock in the name of another company. Owning the stock through a pass-through entity or a trust does qualify.)
- Have bought the stock or received it as part of your compensation at its original issue, not on a secondary market.
Typical professional service-based businesses, like a health-care practice, law firm or financial planners, are ineligible. Also any business whose main asset is its employees’ skills — e.g. freelancers or consultants — can’t be considered a qualified small business.
In short, the provision is well-suited for tech startups, but benefits various other businesses as well.
QSBS holding period
One key point to know as a founder: You have to hold onto your ownership in the corporation for at least five years if you want to qualify for the QSBS tax rate when you exit.
That means you need to have thought about this long before it’s time to sell your company.
As Sam Parr, founder of newsletter and events company The Hustle, geared up to sell the startup in 2021, he honed in on this date to time his sale to HubSpot strategically for the tax savings.
“I knew exactly when the five-year period was,” Parr told Alexis Grant in a podcast interview for They Got Acquired. “I was tracking that like crazy.”
Josh Pigford also leaned on QSBS when he sold his Saas firm Baremetrics in 2020.
QSBS tax rate
How much you’ll owe in taxes from selling QSB stock through an acquisition depends on when you acquired the stock and, possibly, your taxable income.
How much of your gains are exempt from federal tax varies based on when you acquired the stock.
Your best bet here is to read the fine print from the Small Business Administration, but here are the basics:
- For stock acquired after Sept. 27, 2010: there’s no tax on the gain. It’s free from income tax, alternative minimum tax, and the 3.8% net investment income tax.
- For stock acquired between Feb. 18, 2009 and Sep. 27, 2010: you can exclude 75% of the gain, and 7% is subject to alternative minimum tax.
- For stock acquired before Feb. 18, 2009: you can exclude up to 50%, and 7% is subject to the alternative minimum tax.
For remaining gains that aren’t exempt from taxes, you pay capital gains tax, with a rate based on your taxable income for the year. As of the 2021 tax year, typical capital gains tax rates for single individuals are:
- Up to $40,400 in taxable income: 0%
- $40,400 to $445,850: 15%
- More than $445,850: 20%
However, the IRS says the QSBS tax rate can be as high as 28%.
Does a QSBS sale make sense for your business?
The potential for significant tax savings makes the QSBS tax exemption an exciting prospect for founders looking to sell. Yet, most sales for small businesses are still asset sales, not equity sales.
Alicia Goodrow, an M&A attorney with Culhane Meadows who works with owner-managed private companies, says that’s because Section 1202 isn’t a good fit for most companies.
As Goodrow explains it, Section 1202 was written in the wake of The Great Recession as an incentive for investors to put money into small businesses — with hopes of recapturing the kind of energy we saw in the economy during the dot-com boom of the late 90s. The carve-out favors tech companies that are built to sell relatively quickly.
In the dot-com era of building tech companies, VCs got in, because “there was cash at the end of the rainbow,” Goodrow says. “And the rainbow was really short.”
Most companies don’t operate that way, she says. If you’re starting a company with the intent to operate it, even if you’re open to selling at some point, structuring with QSBS in mind could add unnecessary bumps in the road.
The C corp requirement, Goodrow points out, could be prohibitively onerous for some small companies outside the tech sphere. Corporate formalities like annual meetings, electing a board or ratifying an annual report are particular and easy to mess up, which opens you up to legal issues a small company probably isn’t equipped to manage.
However, companies in tech, which are often structured as C corps with VC funding in mind, are a natural fit for QSBS sales, said Christopher A. Karachale, a Silicon Valley–based partner with the business law firm Hanson Bridgett.
“In this sort of more traditional startup world, I don’t see [a C Corp structure] as an issue,” Karachale said.
Why some buyers don’t like acquiring C corps
Outside of Silicon Valley, Goodrow said most buyers she encounters are looking for LLCs.
“C corps are bad tasting to P.E. [private equity] groups and roll ups and other groups that are structured as pass-through structures. They don’t want to buy equity,” Goodrow explained, referring to C Corps.
Stock deals for small companies are usually less attractive to buyers, whose long-term tax strategy revolves around a portfolio of LLCs.
If you’ve structured your company and exit plan around a QSBS sale and run into a buyer who was hoping for an asset sale, be willing to negotiate, Karachale said.
“Buyers traditionally, maybe in the middle market, want to do asset sales, but that’s just a negotiating point,” he said. Because of the massive tax savings for QSBS, you have a lot of room to adjust your price to make a stock sale more attractive to a buyer and still come out ahead.
Entrepreneur Hainstock learned this during his sale of ZoomShift.
“We figured that we’d be able to sell ZoomShift as a stock deal, and traditionally businesses of our size are sold as assets,” Hainstock said. “[The buyers] were under the impression they were going to buy it as an asset. … We thought the deal might just fall apart there.”
The parties were eventually able to get on the same page and go through with the QSBS sale that saved Hainstock on taxes.
However, if you’ve structured your company as a C corp and can’t get your buyer on board with a stock sale — if they insist on an asset sale — you could actually carry a higher tax liability than you would if you’d structured the company as an LLC.
That’s why this can be a tricky decision to make years before you plan to sell. Choosing whether to incorporate as a pass-through LLC or a C Corp is “a hell of a dice roll, said Mario V. Lucibello, CPA and Partner at accounting firm Greenhaus, Riordan & Co., where he advises business owners on tax implications ahead of acquisitions. If buyers refuse to purchase shares and buy your C Corp assets, you could see tax rates of 40% or more on an exit, whereas if you’d sold the assets of an LLC instead, the max is typically 20%, he said.
QSBS checklist: 4 steps to prep for a future QSBS sale
If you know a stock sale is in your future, you can organize your company now to prepare for Section 1202 tax savings.
“Getting a proper strategic tax and legal structure in place before you even begin the company,” says Wekherlien of Tax Goddess, will ensure you can “properly qualify for this fantastic exclusion.”
Consult with an experienced M&A attorney, and take these steps to make sure your company qualifies when it’s time to sell.
1. Make sure you’re in an eligible industry
For your company to be considered a qualified business under Section 1202, the code says you have to operate in a “qualified trade or business,” which includes all businesses except:
- Services businesses in health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services or brokerage services
- Businesses whose principal asset is “the reputation or skill of one or more” employees — for example, freelancing or service businesses like coaching, speaking, arts or crafts
- Financial services, including banking, insurance, financing, leasing and investing
- Hospitality businesses, including lodging and restaurants
Generally, technology, retail, wholesale and manufacturing companies can be considered qualified small businesses.
2. Form a C corp in the United States
To be a qualified small business, your company needs to be a U.S.-based C corporation as recognized by the IRS.
Other business entities are ineligible, so if you currently operate as a sole proprietorship, partnership or LLC, work with a legal expert to take the next step to incorporate.
Unless you know you’re building to sell from the beginning — and have a clear path to exit — Goodrow recommended structuring your business as an LLC to start. You can always shift gears later and restructure into a C corp if you see a future path to a QSBS sale, but you can’t restructure a C corp into an LLC if you discover that’s your best option.
3. Own your stock for 5 years
To qualify for a tax break, the QSBS holding period is five years. Consider this requirement if you have any notions of exiting your company in the future.
Working with financial and legal advisors early can help you set your company up to save a lot of money during a sale. Knowing how much you stand to save after the five-year mark can also help you plan your sale strategically, like Parr did with The Hustle, so you don’t miss out on those tax savings.
Karachale noted a late shift to C corp or a quick sale doesn’t have to derail your tax break, though.
A parallel provision, Section 1045, lets you claim the QSBS tax exemption after holding the stock for just six months — as long as you reinvest the gains into another qualified small business. You can then sell the shares after a total of five years (from when you obtained them in your business) and qualify for the tax exemption.
4. Work with an attorney on the details
While ensuring your company is eligible for a QSBS tax break is fairly simple and straightforward, the sale itself can be much more complex if you’re working with investors or partners.
Gardner suggests founders in this case take care to “design a well-developed capitalization table,” considering who has what percentage of ownership, the value of each investor’s equity and how shares are structured — all of which can make stock deals more complicated than asset sales.
Before you even start talking to potential buyers, consult an attorney with experience selling companies like yours — including your size, structure and in your industry — to set yourself up to appeal to buyers and get the best possible deal.
Looping in an M&A attorney early is smart, even if you don’t have a clear path toward selling yet. They can help you check in on your goals regularly and adjust as you go, so you’re in the best possible shape when you’re ready to sell.
‘Begin with the end in mind’
Although Goodrow doesn’t work with companies built with quick exits in mind, she does help founders keep in top shape for a potential sale. She checks in with companies at least a couple of times a year to adjust to their goals — whether that’s raising money, selling the company or anything in between.
“I’m a big believer [that we] begin with the end in mind,” Goodrow says. “Beginning with the end in mind is really about defining what their goals are early.”
Karachale and Goodrow both cautioned not to get so caught up in potential tax implications that you don’t make the best moves for your company.
“Don’t let the tax tail wag the dog here,” Karachale said.
That is, if you’re faced with a good opportunity to sell but you haven’t had five years to prepare for a QSBS sale, an asset sale could be a better move than waiting just to get the tax break. You may not want to operate the business for another several years — and buyers might not be willing to wait, either.
We’re reporters, not financial advisors. If you need help with financial decisions, please hire a finance professional. The information contained in this piece is provided for informational purposes only, and should not be construed as financial advice.