The Best Kept Secret of QSBS
Most venture capitalists know of the qualified small business stock (“QSBS”) tax exemption. However, as a venture capital lawyer, I often see fund managers not concern themselves with QSBS until after a portfolio company exits. By then, it may be too late to correct the record. They also often miss out on the best kept secret of QSBS called “trust stacking”, which we’ll cover in this article.
QSBS: What’s the big deal?
Recently, my wife and I finished a wonderful meal at our favorite restaurant. On our way out of the parking lot, we remembered something that we had forgotten about since the last time we visited. Parking is free with validation. So, I ran back into the restaurant and returned with my validated ticket. QSBS is like parking validation for your shares. Parking fees are like taxes. Why pay for parking when there’s a way to park for free?
In 1993, the United States Congress passed Section 1202 to encourage long-term investing in small businesses. Since 2010, venture capitalists have qualified for 100% QSBS tax exclusion. Instead of tax rates at 23.8% (or more), federal taxes are zero, up to each person’s QSBS limits. Not only are VCs eligible for QSBS, each limited partner in a venture fund can exclude 100% of their taxable income up to (i) $10 million, or (ii) 10x their original investment, whichever is greater.
In 2019, Congress estimated federal taxpayers wrote off $1.2 billion in QSBS-related income, which didn’t include the taxes saved from the taxpayers living in the 46 states that follow QSBS.
How to qualify?
To qualify for QSBS, (1) you must acquire original issued shares, (2) directly from a qualified small business taxed as a C-corporation (3) that has no more than $50 million in aggregate gross assets, and (4) hold onto such shares for at least 5 years. The key is whether the company has “aggregate gross assets” of $50 million or less.
“Aggregate gross assets” just means the amount of cash and the aggregate adjusted tax basis of property held by the company. This number is calculated by accountants and most often found on the company’s balance sheets.
This is a high-water mark test: Once a company reaches $50+ million in aggregate gross assets, the QSBS tax exemption is permanently lost to all future shareholders of the company.
For example, if a venture capital fund invests $20 million in one of its portfolio company’s Series B round, and the company has $35 million in gross assets on its balance sheet, the Series B shares held by the fund will not qualify for QSBS. To check whether adjusted gross assets is less than $50 million, add the cash from the equity round ($20 million) to the gross assets ($35 million), which means $55 million is greater than $50 million, failing the aggregate gross assets test.
QSBS applies to all types of taxpayers, not just VCs. For example, QSBS applies to founders, employees and advisers issued restricted stock by the company. It also applies to angel investors. It even applies to investments made through limited partnerships and limited liability companies taxed as partnerships, such as LPs in venture funds, members of SPVs, and investors in AngelList’s Rolling Fund vehicles.
Notable exceptions to who can use QSBS are: (1) corporate owners (although S-corporations qualify) and (2) self-directed investment retirement accounts (IRAs). IRA-related income returns as ordinary income and will lose QSBS status. Fund managers should speak to their tax advisers before transferring early-stage investments into an alt-asset retirement account.
The key is the shares must be “original issuance,” acquired directly from the company. For example, common investor strategies for acquiring more ownership in a company (e.g., outside of a primary financing context) might include providing liquidity to founders, leveraging secondary exchanges or via a tender offer of startup employee equity. Unfortunately, unless directly issued by the company, none of those securities would qualify for QSBS for the investor.
The best kept secret of QSBS?
“Trust Stacking”. Perhaps the best kept secret of QSBS is the ability to gift $10 million (or more) of QSBS-eligible gains to one’s children in trust, which saves up to $2.38 million in federal income taxes, plus state taxes in the 46 states that follow federal law, with notable exceptions in California, Mississippi, Pennsylvania and Wisconsin.
I discovered this method after one of my own clients used this procedure to “stack” his QSBS gains in three separate trusts for his three children, thereby multiplying $10 million in tax-free income for each child. That meant an additional $30 million in tax savings, preserving generational wealth for his family. All because of a simple tax loophole.
There’s a lot of information in this article. Believe it or not, a truly detailed analysis of QSBS can go on even longer. Please consult with your legal and tax advisers with respect to your particular circumstances to get the best guidance on this complex yet beneficial tax benefit.
About the Author
Chris Harvey is Principal of Harvey Esquire, a law firm that represents emerging fund managers and VC-backed startups in early stages. Chris has been practicing law for over 12 years as a venture capital lawyer. He writes a monthly newsletter, Law of VC, where he provides deep insight and personal experience on all things venture law related. Chris is also a top writer on Quora. Follow Chris on Twitter or LinkedIn.