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How to Get 100% Tax Free Gains on the Sale of Your Start-Up/Emerging Growth Technology Stock

How to Get 100% Tax Free Gains on the Sale of Your Start-Up/Emerging Growth Technology Stock

Qualified Small Business Stock – Windfall For Investors and Stock Option Holders

As we all know, the Internal Revenue Code (“IRC”) is rife with complexity. Rules and regulations are so difficult to understand, the IRS themselves often misinterpret the guidance. As a consequence, it is not uncommon for great tax breaks and strategies to go unnoticed by even the best advisors. Internal Revenue Code (“IRC”) Section 1202 provides just such a tax break, one of the most fruitful in recent memory that is tailor made for the start-up and emerging growth technology community.

IRC 1202 lays out the rules and regulations relating to investment in Qualified Small Business Stock (“QSBS”). QSBS has been around for a long time, and has never been a tax incentive that created a great deal of buzz. However only recently, as a result of changes in legislation, the incentive has created a window of opportunity that can save an investor millions of dollars if recognized and employed (and conversely, could cost a fortune if missed).

What Is Qualified Small Business Stock?

So let’s talk about the details. First, shares of stock held in a Corporation (not an S corporation or LLC) can qualify to be treated as QSBS if it was “originally” issued (issued for the first time) after 1993 in exchange for money, property or services. In addition, the stock must be issued to a “non-corporate” shareholder, so generally to individuals. Second, prior to, during and immediately after the issuance of the stock, the company’s gross assets must be less than 50 million dollars. Third, during the time the holder possessed the stock, at least 80% of the value of the corporation’s assets must be used in the “active conduct” of a “qualified business”. A qualified business includes typical activities that a tech company would participate in, such as the act of engaging in research and development activities to create and develop the company’s idea and/or product. In addition, assets (such as cash or investments) held to meet the future working capital needs of a qualifying business or expected to be used within two years to finance research and development activities are treated as used in the active conduct of the business as well; hence, receiving a large round of financing would not result in disqualification. While this may seem simple, there are nuances to the qualification that can be complex and certainly would require a detailed analysis by your company’s accountant.

So Why Do You Care If You Are A QSBS?

While QSBS has been around since 1993, the “preferential” tax rates that were applied to the sale of QSBS were hardly significant, so in practice few investors really gave it much attention. However, a provision in the Small Business Jobs Act of 2010 allowed for a holder of QSBS to exclude from taxable income 100% of any gain realized on the sale of their stock if it was held for more than five years and if the QSBS was acquired between September 2010 and December 31, 2011. This window has subsequently been extended through December 31, 2013. Also, the bill allows a holder can exclude 75% of gain if the QSBS was acquired between February 2009 and September 2010. There are some limitations that should be considered, for example, the exclusion is limited to the greater of either $10,000,000 of gains or 10 times the holder’s basis in the stock in question. However, in large part, the Internal Revenue Service has essentially created pockets of time that holders of stock can enjoy virtually tax free gains from the sale of their investment.

Required Holding Period to qualifyDecember 15, 2016

Stock Acquired 10,000 shares of ABC Corp.
Date Acquired December 15, 2011
Purchase price $100
Sale Price $5,000,000
Federal Tax $0

What Do I Do?

If You Are A Stock Option Holder:

Stock option holders have a unique opportunity to position themselves for future tax free gains. If you are a stock option holder, you don’t actually own shares in your startup, thus you would fail the first test noted above. However, exercising your stock options prior to December 31, 2013 would allow you to have purchased your shares within the 100% exclusion time frame. You need to ask yourself a few questions:

  1. Does the company qualify as a qualified small business (does it meet the tests above)?
  2. Do you think you would/could hold the stock for at least 5 years (the company will not sell or be acquired prior to that period)?
  3. Are you willing/able to pay for the shares and exercise today?

If the answer is yes to all three questions, you should strongly consider exercising your options prior to the end of the year!

If You Are A Founder Of A StartUp That Is An LLC:

If you are the owner/founder of a startup that is an LLC you may want to consider converting your LLC into a C-corporation prior to the end of 2013, because as noted above, only stock in a C Corporation can qualify as QSBS. There are a myriad of considerations here, for example the owners of LLC’s generally desire to enjoy tax deductions for losses generated by the company which flows onto the personal returns of the owners (an advantage that a Corporation does not provide). Converting to a Corporation is accompanied by strategic risks (such as corporate level taxation) that an LLC “unit holder” may not have bargained for. This should be a careful and well thought-out process with your advisors; however, if the decision is made to attempt to qualify as QSBS, time is of the essence.

If you currently hold stock in a startup or emerging growth technology company: As a stockholder, you need to either evaluate or have your advisors evaluate your portfolio of investments to determine if any of them qualify as QSBS. The greatest risk you have as an investor in this scenario is if you hold stock that qualifies and neither you nor your advisors know it. Failure to properly identify QSBS if you sell it for a significant gain could cost you a fortune. For example, a sale of stock that generates a gain of $5M would generally result in federal tax that ranges from $1.1M to 1.4M. Certainly a nice chunk of change that you don’t want to inadvertently pay the IRS!

In conclusion, Qualified Small Business Stock presents an incredible opportunity for investors and holders of stock options in startup and emerging growth technology companies. Understanding how this strategy works and its impact on your potential future tax burden is an enormous opportunity that you can’t afford to miss. If you need any assistance understanding IRC 1202 and how it may apply to you or your investments don’t hesitate to contact the WithumSmith+Brown startup and emerging growth technology team.

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