Qualified Small Business Stock (QSBS): The $10 Million Tax-Free Exit Every Founder Must Know
Qualified Small Business Stock (QSBS): The $10 Million Tax-Free Exit Every Founder Must Know
COACHING POINTS
- The Holy Grail: Under IRC Section 1202, if you hold stock in a qualified C-Corporation for more than 5 years, you can exclude up to 100% of the capital gains from federal tax.
- The Limit: The exclusion is capped at the greater of $10 million or 10x your cost basis. This means a founder with virtually zero cost basis can walk away with $10M cash, tax-free.
- The “Stacking” Hack: Savvy founders don’t stop at $10M. By gifting stock to Irrevocable Trusts (for kids or spouse) before a liquidity event, each trust can potentially claim its own separate $10M exemption.
Most tax strategies act as a shield (reducing damage). QSBS acts as an eraser.
It was designed by Congress to encourage investment in small ventures. For founders and early employees, it transforms a “good exit” into a “generational wealth event” by removing the federal government from the payout line entirely.
Source: IRC Section 1202 (Small Business Job Protection Act)
Comparing a Standard Exit vs. a QSBS Exit for a Founder.
- Exit Scenario: You sell your startup for $10,000,000. Basis = $0.
- Without QSBS (Standard Long-Term Cap Gains):
Federal Tax (20%) + NIIT (3.8%) = 23.8%.
Tax Bill: ~$2,380,000.
Net Proceeds: $7,620,000. - With QSBS (Section 1202):
Federal Exclusion: 100%.
Tax Bill: $0.
Net Proceeds: $10,000,000. - Impact: You keep an extra $2.4M simply by checking the right legal boxes at incorporation.
What-If Scenario: The “Rollover” Escape Hatch (Section 1045)
Problem: You need to sell your startup stock after 3 years (before the 5-year mark).
| Strategy | Tax Implication |
|---|---|
| Cash Out Now | Taxed Fully (Long-Term Capital Gains). The QSBS benefit is lost because the 5-year clock wasn’t met. |
| Section 1045 Rollover | Tax Deferred. If you reinvest the proceeds into another QSBS-qualified startup within 60 days, the tax is deferred, and the 5-year clock keeps ticking. |
Result: Section 1045 allows serial entrepreneurs to move from one startup to another without triggering taxes, preserving the path to the $10M exemption.
Visualizing the Windfall
| Exit Strategy ($10M Sale) | Taxes Paid to IRS ($) | Cash to Founder ($) |
|---|---|---|
| Standard Equity Sale | 2380000 | 7620000 |
| QSBS Qualified Sale | 0 | 10000000 |
*The QSBS exemption effectively provides a 30% bonus on your exit by eliminating Federal Capital Gains and NIIT. (Note: Some states like CA do not conform to federal QSBS rules).
Execution Protocol
You generally cannot claim QSBS on S-Corp or LLC shares. You must hold stock in a Domestic C-Corporation. If you are an LLC, you must convert to a C-Corp, and the clock starts on the conversion date.
The company’s gross assets must be under $50 million at the time the stock is issued to you. If the company grows to $1B later, that’s fine—as long as it was “small” when you got in.
At least 80% of the company’s assets must be used in an “active trade or business.”
Excluded Industries: Banking, Hospitality (Hotels/Restaurants), Farming, and Professional Services (Doctors/Lawyers/Consultants). It is mainly for Tech, Manufacturing, and Retail.
COACHING DIRECTIVE
- Do This: If you are founding a scalable startup. Incorporate as a Delaware C-Corp from Day 1 to start the 5-year QSBS clock immediately.
- Avoid This: If you run a service business (e.g., Marketing Agency, Law Firm). Section 1202 explicitly excludes businesses where the “principal asset is the reputation or skill” of the employees.
Frequently Asked Questions
What is QSBS (Section 1202)?
It stands for Qualified Small Business Stock. It is a tax provision that allows non-corporate investors to exclude up to 100% of federal capital gains on stock held for at least 5 years.
Does it apply to LLCs?
No. QSBS applies only to C-Corporations. However, if you hold an LLC membership interest, you may be able to convert to a C-Corp. The 5-year holding period begins on the date of conversion.
What is ‘QSBS Stacking’?
The $10M limit applies per taxpayer. ‘Stacking’ involves gifting shares to multiple non-grantor trusts (e.g., one for each child). Each trust is a separate taxpayer and may claim its own $10M exclusion, potentially shielding $30M, $40M, or more.