Due to the dynamic nature of launching a new business, it can be challenging for a startup to keep up with all of the latest changes to the tax code. But Founder Stock, in Section 1202 of the Internal Revenue Code, is one tax exclusion startup founders should certainly be aware of. In fact, all in the startup ecosystem — venture capitalists, angel investors and entrepreneurs alike — can take advantage of this unique feature of the tax code.
Founder Stock provides a tax exclusion on gains in certain small business stock sales. When selling qualified stock, an individual can exclude gains of up to $10 million, or 10x adjusted basis of stock, in gains from income tax.
How can I qualify for this tax exclusion?
To take advantage of the potential exclusion, a business must first show proof they qualify as a Qualified Small Business Company (QSBC). General guidelines to qualify as a QSBC are outlined in Section 1202:
- The stock must be in a domestic C Corporation
- The corporation must have less than $50 million dollars in revenue or assets on date the stock is acquired
- The majority (80 percent) of the value of the corporation’s assets must be actively used in the handling of the qualified businesses (not an investment vehicle or an inactive business)
In Barry’s experience, it’s probable most early-stage C corporation companies have the ability to meet these requirements.
What are the tax benefits?
If the business is qualified as a QSBC, then the stock must be assessed to determine whether it can be considered Qualified Small Business Stock (QSBS). Each shareholder’s interest is reviewed independently. Main requirements in order to receive tax benefits of QSBS are:
- Stock must have been acquired directly from the company while it qualified as a QSBC in exchange for money, property or services
- Stock must have been held for five years
- To maximize benefit, stock must have been acquired after September 27, 2010. If the stock was acquired prior to that date, there are rules for a portion of the benefit to still be utilized
What happens when a company grows past the $50 million mark?
There’s a $50 million aggregate for the gross assets. If I acquire my stock while it’s below that threshold and someone else acquires the stock after it exceeds that threshold, my stock would qualify and theirs would not. Even though the business grows beyond the limit, it does not prevent earlier shareholders from taking the exemption from 1202.
So if you start a small business that becomes fast-growth, once the threshold is passed you don’t lose the benefit of the stock prior surpassing the limits. Only the stock acquired beyond the limits would not qualify.
What if an exemption exceeds your gain?
You’re limited to the gain identified. If I generated a $9 million gain and could have excluded $10 million, I’m limited to only utilizing $9 million of the exclusion.
What are the potential pitfalls here?
First, the five-year requirement is critical. Second, there are legal and financial caveats to consider when electing to become a C Corporation.
To take advantage you have to sell the stock. Buyers generally want to buy assets because with stock, they inherit any liabilities and prior issues. Finally, if you don’t meet the 5-year requirement, you may still be able to save the benefit. In cases where you have stock from one qualified small business and roll that into another qualified small business within 6 months, you benefit from currently excluding the gain. This also may create a situation to not lose the benefit.
Who should take advantage of Section 1202?
If you’re already a C Corporation, there’s no reason not to take advantage of this provision. You didn’t have to know about it when you set it up, you just need to make sure to take the appropriate steps when it’s time to sell the stock. If you were going to set up a new company today, this could be one of the factors in deciding what type of entity best fits your company structure. Founders and the professional advisors should review business model, the investors, goals, exit strategy, timeline, etc. to elect the best entity.