Is startup equity taxable?

When you take an equity stake in a startup, you may receive stock or other equity-based compensation. The IRS taxes this type of compensation as ordinary income , meaning that you'll need to report it on your tax return and pay applicable taxes.

Does QSBS apply to founders?

Qualified small business stock (QSBS) is a type of share issued by a C corporation (C corp) that meets requirements in the Internal Revenue Code, specifically Sections 1202 and 1045. QSBS offers substantial tax benefits to shareholders, most notably founders and early investors .

How do startups avoid taxes?

The Qualified Small Business Stock (QSBS) tax exemption may allow you to avoid 100% of the capital gains taxes incurred when you sell a stake in a startup or small business.

Does startup equity count as net worth?

Equity in privately-held companies counts towards the net worth definition in the first section above, because equity is an asset (like cash in your bank account or your car). If you raised even a modest equity round, the implied value of your shares could be enough to make you accredited.

What is the 5 year rule for QSBS?

Founders and investors can invest in a small business or startup by acquiring qualified small business stock (QSBS), which provides tax advantages. Section 1202 of the US Internal Revenue Code allows investors to exclude up to 100% of capital gains tax on certain small business stocks held for over five years .

What disqualifies QSBS?

Company redemption risks. Redemptions of more than 5% of the aggregate value of the company's stock within a year, and redemptions from a related person to the QSBS holder within a two-year window , can disqualify all of the company's stock from QSBS eligibility.

What is the tax treatment of founders shares?

What is Founder Stock? Founder Stock is a Qualified Small Business Stock (QSBS) that provides a tax exclusion on gains to taxpayers in certain small business stock sales . When selling qualified stock, an individual can exclude gains of up to $10 million or 10 times the adjusted basis of stock in gains from income tax.

How are startup shares taxed?

Short-term capital gains are taxed as ordinary income . The tax rate can range from 10% to 37% depending on your income bracket as per the U.S. federal tax laws (as of 2023). The gain is calculated as the difference between the selling price and the purchase price (cost basis) of the asset.

Is an equity payout taxable?

Your award pays out Ordinary income and FICA * • Your employer withholds these taxes for you. On your W-2, your employer reports the value of your shares as income, along with the amount of taxes withheld. Use the information on your W-2 to complete your tax return.

Is owner's equity taxable?

When you take an owner's draw, no taxes are taken out at the time of the draw. However, since the draw is considered taxable income , you'll have to pay your own federal, state, Social Security, and Medicare taxes when you file your individual tax return.

Is equity investment taxable?

LTCG up to Rs. 1 lakh from equity investments in a financial year is exempted from tax . Any gain above Rs. 1 lakh is taxed at 10%.

Achieving Zero Taxation on Sale of Your Startup Equity

By Robert Adelson on 5 September 20 Executive Employment,Startups

This article was published inCEO Worldon September 3, 2020.

Are you a founder, a C-level or senior executive recruit, or angel investor of a startup life sciences company, a startup tech company, or a startup e-commerce or other high growth company?

If so, did you know that if your startup is properly structured and you hold onto your stock for five years, there may be ZERO Federal tax on the gain when you choose to sell it?

What’s more, even if you sell within five years, you might still achieve zero Federal taxation if you roll-over the proceeds from the sale into one or more similarly qualified small corporations.

What is an IRC 1202 gain? Understanding QSBS Stock and Taxation

If you think the QSBS tax exclusion sounds too good to be true, think again. It was enacted in 1993 to provide an incentive for taxpayers to start and invest in specific types of small businesses. At that time, the law provided a 50% exclusion of limited utility. But with the Great Recession of 2008-2009, the law got a big boost to a 100% exclusion. Originally, it was year to year but then made permanent. Thus, all QSBS acquired after September 27, 2010 are eligible for the 100% exclusion.

Today, the statute continues to provide an exclusion from profits made on any exchange or sale of QSBS stock. The 100% exclusion from Federal taxation applies to all Federal taxation on capital gains, and also includes exclusions from theAlternative Minimum Tax (AMT)and the Net Investment Income tax (NII).

However, restrictions do apply. For example, you must own the stock for five years to take advantage of this fantastic opportunity. But IRC Section 1045 does allow you to roll-over of QSBS to shares of another qualified small business, if the new shares are purchased within 60 days of sale of your prior shares – so you can then continue your holding period to try to reach five years. Remember, too, that not all shares qualify.

How do you know if a business qualifies as a QSBS? For all intents and purposes, garden-variety C corporations and QSBSs are one and the same when it comes to tax and legal purposes. That’s why specific restrictions have been stipulated.

Image by Steve Buissinne from Pixabay

Which businesses and stock qualify for Section 1202?

To be eligible for a tax exclusion, the stock you purchase must meet the following requirements:

It must be acquired through inheritance, gift, or upon original issuance
At the date of stock issuance, the corporation must be a QSBS
It must be a QSBS during substantially all the period you hold it
You must acquire it in exchange for other property (not including stock), money, or services

At this point, you may be wondering what rules a corporation must meet to be considered a QSBS. They include being a domestic C corporation. The corporation must also be deemed an active business. To fulfill this requirement, at least 80 percent (by value) of its assets must get utilized in its active conduct and not ownership of real estate or passive investments.

Businesses Excluded from Section 1202

Besides meeting the restrictions described above, certain businesses are excluded from QSBS standing. They include companies involved in:

Banking, insurance, financing, leasing, investing activities
Agriculture and farming
Operation of a motel, hotel, restaurant, health clubs, entertainment
Production or extraction of natural gas, oil, or other natural resources
Performance of services in the fields of health, law, architecture, engineering, athletics, and general consulting.

The list above is by no means comprehensive. So, make sure that you consult with an experiencedstartup tax attorneybefore making any significant decisions.

Despite these exclusions, most companies engaged in production in the high growth innovation areas economy are going to qualify – life science, tech, e-commerce, etc.

Besides the nature of the business, there is a size limitation as well to be a qualified small business corporation. To qualify, the C corporation cannot possess gross assets over $50 million before and immediately after issuance of the stock to you.

Limitations on Excludable IRC 1202 Gains

Other limitations to your tax-free capital gains also exist. For example, tax limits on your eligible gain exclusion must not exceed the greater of:

$10 million reduced by the number of eligible gains already accounted for in prior tax years from the sale of other QSBS stock (or, $5 million for those who are married but filing separately)
Ten times the aggregate adjusted basis in the QSBS shares sold

Effect of Built-in Gain with LLC Units Converted to QSBS

An exception is allowed to the C corporation requirement. If the entity was a partnership or LLC when you acquired your interest and there is a later conversion to C corporation status, and your interest converts to C corporation shares in a tax-free exchange, then your shares would be eligible as QSBS, with the holding period and tax basis in your stock starting on the date of conversion.

There is further exception to the exclusion limits in the case of LLC or partnership units converted to C corporation stock that can qualify as QSBS. If yourstartup equitywas originally held in an LLC or partnership, then at the time of conversion to C corporation, a determination is made as to fair market value of your equity position, and from that value the determination is made as to limits on excluded 1202 gain.

This rule can work in your favor or against you depending on the company’s success. For example, your tax basis is $100,000 but at the time of LLC conversion to a C corporation, the fair market value of your stock is $10 million, and then you sell six years later. If your sale price is $15 million, only $5 million would be excluded from your $14,900,000 gain, with the remaining $9,900,000 taxable because it was built in gain attributable to appreciation while held in the LLC. However, if instead, you sold your shares for $80 million, then the same $9,900,000 would taxable because it was built in gain attributable to the LLC, but now the $70 million gains above $10 million would be excluded from taxation because you are permitted to exclude up to 10 x the fair market value of shares at the time of conversion.

Planning your Executive Equity Package to use QSBS to your benefit

As a CEO or otherC-level executiveconsidering a job offer with a startup or other qualified small business corporation, it is wise to consider the following planning features in connection with your move.

Obtain stock not options– only actual stock issued will qualify as QSBS and start your holding period to qualify for tax free treatment
IRC Section 83(b) election– Make the 83(b) tax election over unvested shares: to the extent you hold options or no such tax election is made, you will be taxed at ordinary income rates until shares vest or non-qualified options are exercised.
Assure business is qualified– If you receive LLC units, be sure that the conversion occurs when the business is still under $50 million in gross assets or otherwise still a qualified small business corporation at the time of conversion when shares are issued to you.
Plan your roll-over if needed– If your company is in play and the sale likely to occur within the 5-year holding period, then, so long as you have held your QSBS stock more than 6 months, plan to diversify, using the proceeds to invest in other QSBS, where if such purchases are made within 60 days of sale, you can then tack your holding period, and later achieve tax free treatment when you sell those shares after the 5-year combined holding period.

How to Achieve Zero Taxation on the Sale of Your Company Stock

In this article, we’ve discussed many of the critical rules to help you better understand the opportunities offered by QSBS despite the different restrictions and limitations. We’ve discussed QSBS in terms of timeframes and business types. We’ve also examined stock eligibility and finance restrictions that apply.

Tips have also been offered in structuring yourexecutive equity compensationas a CEO, C-level or senior executive joining a qualified small business corporation. If this sounds like an opportunity that may benefit you, it is wise to discuss this further an experiencedexecutive employment and tax attorneyfor additional assistance.

Achieving Zero Taxation on Sale of Your Startup Equity | Attorney Robert Adelson (2024)