In the early days of startup formation, it’s helpful to think years into the future — more than five years, to be exact. That’s the minimum term to which the Qualified Small Business Stock (QSBS) tax exemption applies.

QSBS is a big incentive for structuring your U.S.-based business as a C corporation (or converting from an LLC) because it’s reasonable to assume your investors will someday want to exit. When they do, they could be looking to qualify for this huge tax break.

What is the Qualified Small Business Stock exemption?

The QSBS exemption is part of Section 1202 of the Internal Revenue Code enacted in 1993. It grants a significant tax break to small business investors and is, therefore, something you should understand when you first start raising capital. 

There have been additions and changes to the QSBS code over the years, but the core qualifications are as follows:

• The exemption only applies to stock granted by a C corporation
• The company must have less than $50 million in net assets
• The grantee must have held the stock for a minimum of five years

Essentially, this applies to early investors with vested stock. 

When they’re ready to sell their shares, qualifying investors enjoy a significant tax break: a 0% tax rate on the first $10 million of gain or 10 times their adjusted basis in the stock — whichever is greater.

QSBS qualification is wildly appealing for obvious reasons: It allows people to avoid paying tax on most (or all) of their capital gains. This includes you and your founders or employee-shareholders, too — should you ever choose to sell the business.

Taking advantage of QSBS when you sell a business

If, more than five years from now, you decide to exit your business, you could qualify for the QSBS exemption and end up with the greatest profit possible. There’s one caveat, though: You must sell it entirely — assets, liabilities, and all.

There are two different ways people buy businesses:

1. They acquire the owner’s stock and, with it, all of their interest in the business — they step into the owner/operator’s shoes
2. They buy assets only, e.g., intellectual property or customer lists

In the second case, QSBS does not apply. So if you want to qualify for the tax break, you need to give up all your interest in the business.

When you, as the seller, understand the ins and outs of the QSBS exemption, you can ensure you know what you’re getting into taxwise before closing the deal.

If you play your cards wisely, the QSBS exemption can be a win-win for you and everyone else who invests in your startup.

This article is based on an episode of the WTFAQ Podcast.