The $10 Million Loophole: How Section 1202 (QSBS) Wipes Out Your Tax Bill
The $10 Million Loophole: How Section 1202 (QSBS) Wipes Out Your Tax Bill
COACHING POINTS
- The Holy Grail: Qualified Small Business Stock (QSBS) under Section 1202 allows you to exclude 100% of your capital gains from federal tax, up to $10 million or 10x your cost basis (whichever is greater).
- The Requirements: To qualify, the stock must be from a domestic C-Corporation (not LLC/S-Corp), with gross assets under $50 million at the time of issuance, and you must hold it for at least 5 years.
- The Strategy: This is the primary reason why high-growth startups incorporate as Delaware C-Corps. If you are a founder or early employee, ensuring your shares are QSBS-eligible is worth millions in future tax savings.
In a world where high earners pay 23.8% (Federal) + 13.3% (State) in taxes on sales, QSBS is a “Get Out of Jail Free” card. The government created this massive incentive to reward risk-takers who fund small businesses. If you hit a home run with a startup exit, Section 1202 ensures the IRS doesn’t take a third of your winnings. Source: IRC Section 1202 / 1045 Rollover Rules
Scenario: You invested $100,000 in a startup. 7 years later, you sell your stake for $10,100,000.
- Gain: $10,000,000 profit.
- Standard Tax (Without QSBS):
Federal Cap Gains (20%) + NIIT (3.8%) = 23.8%.
Tax Bill: $2,380,000. - With QSBS (Section 1202):
Exclusion: 100% of the first $10M.
Tax Bill: $0. - The Difference: You keep an extra $2.38 million in your pocket simply because the company was structured correctly as a C-Corp.
Tax Liability on $10M Exit
| Scenario | Federal Tax Paid ($ Millions) |
|---|---|
| Standard LLC/S-Corp Sale | 2.38 |
| QSBS C-Corp Sale | 0.00 |
*The structure of the entity at the time of issuance determines whether you pay millions or zero. LLC units generally do not qualify unless converted early.
What-If Scenario: The “Stacking” Hack
Comparison: Single $10M Limit vs. Multiplying the Limit via Gifts.
| Strategy | Total Tax-Free Capacity ($ Millions) |
|---|---|
| Founder Only | 10 |
| Founder + Spouse + 2 Kids (Gifting) | 40 |
Execution Protocol
You must buy the stock directly from the company (or receive it as compensation). Buying shares from another shareholder (secondary market) disqualifies you from QSBS.
You must hold the stock for 5 years. If the company is sold after 3 years, you don’t get the exclusion. However, you can use a Section 1045 Rollover to reinvest the proceeds into another QSBS-qualified startup within 60 days to keep the tax-deferral alive.
Not all states honor the federal QSBS exclusion. California and New Jersey, for example, do not conform (or partially conform), meaning you might pay 0% Federal tax but still owe 13% State tax. Always check your state’s rules.
COACHING DIRECTIVE
- Do This: If you are starting a scalable company, incorporate as a C-Corp from Day 1 (or convert quickly). The “double taxation” of C-Corps is often outweighed by the QSBS exit benefit.
- Avoid This: Holding QSBS in an IRA. IRAs already shield taxes (or defer them), so the QSBS benefit is wasted. Hold these moonshot stocks in a taxable account to maximize the tax-free delta.
Frequently Asked Questions
What if I have an LLC?
LLC units do not qualify. However, if you convert your LLC to a C-Corp, the clock starts ticking from the conversion date. The 5-year holding period begins then, and the basis is reset to the fair market value at conversion.
Is there an income limit?
No. Unlike Roth IRAs, Section 1202 has no income limits for the investor. It is available to billionaires and early employees alike.
What businesses are excluded?
Service businesses (law firms, doctors, consultants), banking, farming, and hospitality (hotels/restaurants) are generally excluded. It is designed mostly for “technology” and “manufacturing” businesses.