Using QSBS for Huge Executive Tax Savings: To Sell Your Startup Shares Tax-Free

By Robert A. Adelson

If you are a successful executive considering a job offer or move to take a CEO, C-level, or senior executive position with a startup, early-stage, or small company, QSBS can be a key objective to seek and negotiate for as part of your executive compensation package.  This article defines QSBS and walks you through how this special type of stock can potentially be sold with ZERO ordinary income or capital gains taxes.  This can potentially save you as much as $2.3 million in taxes if “your ship comes in” and your shares are sold at a $10 million profit. 

🔹 What is QSBS? 

QSBS is a Qualified Small Business Stock under tax code Section 1202. 

The stock must be originally issued to you rather than acquired through secondary transactions.

The company that issues and sells its stock to you must be a domestic C corporation that is also a Qualified Small Business under 1202. This typically means the business has gross assets of $50 million or less at the time the stock is issued. 

🔹 Is Your Employer’s Business Eligible as a Qualified Small Business?  

First, a Qualified Small Business under 1202 must be an active business.  That means at least 80% of the company’s assets must be actively used in business operations during the holding period.  Real estate owned is counted against this amount. 

Additionally, companies involved in activities such as banking and insurance, agriculture, production or extraction of oil and other natural resources, and services in health, law, architecture, engineering, etc., are excluded from QSBS tax exemption. To find out whether your company qualifies, it is best to consult an experienced tax attorney. 

Despite these exclusions, most companies in the high-growth innovation industries, such as life sciences and technology, are likely to be eligible as Qualified Small Businesses. 

🔹 Is Your Employer Eligible as QSB if the Company Is Not a C corporation? 

Only stock in a C corporation is eligible to be QSBS.  However, if your company was an S corporation, partnership, or LLC when you acquired your interest, and it was then converted to a C corporation and your interest then converted to C corporation shares in a tax-free exchange, then your shares would also be eligible as QSBS. The holding period and tax basis of your QSBS stock will start on the date of conversion.

🔹 The Magnitude of Your Potential Tax Savings

If you hold QSBS shares for at least five years, you could be eligible to exclude up to $10 million – or 10 times your original investment, whichever is higher – from taxable gains. 

This includes not only Federal capital gains taxes but investment income taxes too.  

🔹 Avoiding Tax Ambush with Timely 83(b) Election

Though acquiring and holding QSBS shares can potentially save you from taxes on the gains if the shares are held for five years, QSBS does not protect you from a dangerous tax ambush if you are not careful. 

Typically, when QSBS shares are issued, there will be vesting requirements that all or part of the shares are forfeited or repurchased by the company at cost if you leave the company.  If the shares rise in value, you will be taxed on the appreciation as vesting occurs.  This is ordinary income tax and payable even though shares have not been sold and are illiquid.  

To avoid this ambush, at the time shares are issued, within 30 days, you need to make the 83(b) election.  It is an election to be taxed on appreciation right then, even though not yet vesting.  Typically, there will be little tax paid, but it means you won’t face taxation until the shares are sold. 

🔹 Using the “Rollover” to Reach 5 years

If your company is likely to be sold within the 5-year holding period, you should plan to diversify your portfolio by reinvesting the proceeds into other QSBS.  Tax code Section 1045 allows for a tax-free rollover of QSBS shares.   That code section allows you to use the sale proceeds from the sale of all or part of your QSBS shares to purchase shares in other companies within 60 days of the sale.  So, as long as the new shares acquired also meet the requirements to be QSBS shares, there is no tax assessed on the sale for cash of your QSBS shares, and you can then “tack” your holding period from your old shares to your new ones, allowing you to qualify for tax-free treatment, if you hold the shares through the 5-year combined holding period.

Generally, if a sale is to occur, there will be a due diligence period.  It is wise to scout small companies where you can be issued shares so that when the sale closes, and you now have 60 days to roll over sale proceeds, you then are ready to reinvest and thus diversify. 

QSBS as Key Startup Executive Recruitment Tool

If your startup equity meets these conditions, the potential tax savings can be immense. This is particularly important if your future employer is anticipating a liquidity event, such as an acquisition or public offering. 

Thus, in structuring your executive compensation package, you want to be sure to get stock, not options. Stock options do not qualify for QSBS tax exemption. You want to ensure that you receive actual stock as soon as possible.  You want to start your holding period ASAP to qualify for tax-free treatment.

And it is not just you. As a CEO, COO, or other C-level leader, you can use QSBS as a key executive recruitment tool to bring in top talent to your team.

In this area, it is wise to work with an experienced executive employment and tax attorney who is well versed in taxation and can help you navigate complex tax rules associated with the QSBS exclusion and ensure you get the maximum gains from your hard work.