QSBS (Section 1202): How to Sell Your Startup and Pay $0 Capital Gains Tax
QSBS (Section 1202): How to Sell Your Startup and Pay $0 Capital Gains Tax
📜 WHO THIS IS FOR (Prerequisites)
- Required Profile: Founders, Early Employees, or Angel Investors in U.S.-based technology or manufacturing startups.
- Primary Objective: Tax Elimination (Achieving a 0% Federal Capital Gains tax rate on an exit up to $10 million).
- Disqualifying Factor: Founders holding shares in an LLC or S-Corp (QSBS applies ONLY to Domestic C-Corporations).
⚠️ STRATEGY ELIGIBILITY CHECK
QSBS is a “Check-the-Box” statute. Failing one requirement voids the entire exemption.
- ☑️ Entity Type: Must be a Domestic C-Corporation. (LLCs and S-Corps do not qualify).
- ☑️ Original Issuance: You must have acquired the stock directly from the company (not on a secondary market) in exchange for money, property, or services.
- ☑️ Gross Assets Test: The company’s gross assets must have been under $50 Million at all times before and immediately after your investment.
- ☑️ Holding Period: Must hold the stock for more than 5 years before selling.
- ☑️ Active Business: At least 80% of assets must be used in an active trade. (Excluded: Hospitality, Financial Services, Farming, Consulting).
*Warning: Converting an LLC to a C-Corp can start the 5-year clock, but only on the appreciation occurring AFTER conversion.
EXECUTIVE SUMMARY
- The Opportunity: If you sell a qualifying startup for $10M profit, normally you would owe ~$2.4M in Federal Taxes (23.8%). With QSBS, you owe $0.
- The Cap: The exclusion is limited to the greater of $10 Million OR 10x your original cost basis per issuer.
- The Trap: Many founders start as an LLC to save on taxes early on, unknowingly disqualifying themselves from QSBS forever. Conversion is possible but complex.
- The Multiplier: Through a strategy called “Stacking” (gifting shares to irrevocable trusts), ultra-high-net-worth founders can multiply the $10M exclusion cap for family members.
Section 1202 is the single most powerful tax code in the venture capital ecosystem. It is the government’s reward for taking the risk of starting a new company. However, it requires planning at the incorporation stage, years before the exit. Source: Andersen Tax / Cooley LLP
- Scenario: Founder sells 100% of startup equity after 5+ years.
- Sale Price: $10,000,000.
- Cost Basis: Assumed near $0 (Founder’s stock).
- Federal Tax Rate: 20% (LTCG) + 3.8% (NIIT) = 23.8%.
- State Tax: Excluded from model (Note: CA and PA do not conform to QSBS and will tax the full amount).
Exit Tax Simulation ($10M Exit)
| Strategy | Net After-Tax Proceeds ($) | Total Tax Paid ($) |
|---|---|---|
| Standard C-Corp Sale (No QSBS) | 7620000 | 2380000 |
| QSBS Qualified Sale (Section 1202) | 10000000 | 0 |
*Chart Note: The QSBS exemption results in a pure $2.38M “Tax Alpha.” This effectively increases the exit value by ~31% without any additional operational risk.
Entity Selection Matrix (Founder’s Dilemma)
*Choosing the right entity at inception determines your QSBS eligibility.
| Feature | C-Corporation | LLC / S-Corporation |
|---|---|---|
| QSBS Eligibility | Yes (If assets < $50M) |
No (Pass-through entities disqualified) |
| Taxation Flow | Double Taxation (Corp Tax + Dividend Tax) |
Single Taxation (Pass-through to individual) |
| VC Funding | Preferred (Standard for Venture Capital) |
Difficult (VCs avoid pass-through income) |
| Exit Strategy | Optimize for Stock Sale (QSBS) | Optimize for Asset Sale |
*Operational Note: While LLCs avoid “Double Taxation,” the QSBS benefit on a lucrative exit (100% exclusion) usually outweighs the annual double taxation cost for high-growth startups.
The Loophole: The $10M limit applies “per taxpayer.”
- Strategy: If a founder anticipates an exit > $10M, they can gift shares to non-grantor trusts (e.g., for children) before the sale.
- Result: Each trust is a separate taxpayer with its own $10M exclusion cap.
Example: Founder + 3 Trusts = $40M Total Tax-Free Exclusion. - Caution: This requires sophisticated drafting to avoid IRS “sham transaction” rules.
⛔ BOUNDARY CLAUSE: Structural Limitations
- State Non-Conformity: California (the hub of startups) does not recognize federal QSBS. You will still owe ~13.3% CA state tax on the gain. (Move to a QSBS-friendly state before sale if possible).
- The “Redemption” Trap: If the company buys back any stock from you or related persons within a 4-year window around the issuance, it can taint the entire QSBS eligibility.
👤 DECISION BRANCH (Logic Tree)
IF Business = Service/Consulting (High Cash Flow):
• Input: Law firm, Accounting, Consulting.
• Output: Use LLC/S-Corp. Not eligible for QSBS (Excluded Industry). Prioritize pass-through cash flow.
IF Business = Tech/Product (High Growth/Exit Focus):
• Input: Raising VC money; plan to sell in 5-10 years.
• Output: Use C-Corp. Accept double taxation now for the potential $10M+ tax-free exit later.
QSBS is the government’s way of saying “Thank you for building the future.” For a successful founder, failing to file the 83(b) election or choosing the wrong entity is a multimillion-dollar unforced error.