Section 1202 (QSBS): How to Sell Your Company for $10 Million Tax-Free
Section 1202 (QSBS): How to Sell Your Company for $10 Million Tax-Free
EXECUTIVE SUMMARY
- The Mechanism: Under Internal Revenue Code Section 1202, founders and early investors in “Qualified Small Business Stock” (QSBS) can exclude 100% of their capital gains from federal taxes upon exit.
- Authority Baseline: This analysis follows the exclusion rules set by the PATH Act of 2015, which made the 100% exclusion permanent for stock acquired after Sept 27, 2010.
- Scope Limitation: This applies only to Domestic C-Corporations (not S-Corps or LLCs) with gross assets under $50M at the time of issuance. Service businesses (doctors, lawyers, consultants) are strictly excluded.
- Anti-Exaggeration: This is not automatic. You must hold the stock for 5 years. If you sell early, you lose the exemption (unless you use a Section 1045 rollover).
For a founder, selling a company is the payday of a lifetime. Usually, the IRS takes 23.8% (Federal) plus State tax. Section 1202 is the golden ticket that sets that rate to 0%. According to Team BMT Analysis, choosing the wrong entity type (LLC vs. C-Corp) at formation is a multi-million dollar error because LLCS do not qualify for QSBS. Source: IRS Instructions for Schedule D (Form 1040)
Scenario: You start a Tech Company (C-Corp) with $10k. 7 years later, you sell it for $10M.
- Standard Sale (No QSBS):
Capital Gain: $10M.
Federal Tax (23.8%): ~$2.4M.
Net Walk-Away: $7.6M. - QSBS Sale (Section 1202):
Capital Gain: $10M.
Federal Tax Exclusion: 100%.
Tax Bill: $0.
Net Walk-Away: $10M. - Verdict: One tax code section saved you $2.4 Million.
Exit Proceeds Comparison
| Scenario | Tax Bill on $10M Gain |
|---|---|
| Standard C-Corp Sale | 2380000 |
| QSBS Qualified Sale | 0 |
*Chart Note: The tax savings alone are often enough to fund a second retirement. Note that some states (like California) do not conform to federal QSBS rules and will still tax the gain.
CRITICAL SCENARIO: The “Multiplier” Hack
How to exceed the $10M limit.
| Strategy | Total Exclusion Limit |
|---|---|
| Founder Only | $10 Million (Per Taxpayer). |
| Stacking (Gifting to Trusts) | $50 Million+ (Each Trust is a separate taxpayer). |
Execution Protocol
You must incorporate as a C-Corp. An S-Corp or LLC does not qualify. If you are currently an LLC, you can convert to a C-Corp, but the 5-year clock starts on the conversion date, and only the appreciation after conversion qualifies.
Decision Order: Confirm Industry (Tech/Retail OK, Consulting/Law NO) โ Incorporate C-Corp.
You must hold the stock for at least 5 years.
Emergency Hatch: If you must sell in Year 3, use a Section 1045 Rollover. This allows you to roll the proceeds into another QSBS-qualified startup within 60 days to keep the tax deferral alive (similar to a 1031 exchange for real estate).
The company must have Gross Assets under $50M immediately after you invest. If the company raises a huge Series C round and assets cross $50M, new stock issued afterwards won’t be QSBS, but your old stock keeps its status.
WEALTH STRATEGY DIRECTIVE
- Do This: If you are starting a high-growth startup seeking VC funding, use a Delaware C-Corp. It aligns with investors and unlocks QSBS.
- Avoid This: Assuming your “Consulting Firm” qualifies. Section 1202 specifically excludes businesses where the principal asset is the reputation or skill of employees (Health, Law, Engineering, Architecture, Consulting).
Frequently Asked Questions
Does California recognize QSBS?
No. California (and a few other states like NJ) does not conform to Section 1202. You will still pay state capital gains tax (up to 13.3%) even if your federal tax is $0.
Can I convert LLC to C-Corp?
Yes. But the QSBS benefit only applies to the value created after the conversion. The value built up while it was an LLC is still taxable. It’s better to start as a C-Corp if the exit is the goal.
What is the 10x Basis rule?
The limit is the greater of $10M or 10x your cost basis. If you invested $5M of cash into the company, your exemption limit becomes $50M (10 x $5M), bypassing the $10M cap.