Qualified Small Business Stock

For the past twenty years, the US federal tax code has included provisions that allow startup investors to get favorable tax treatment on the capital gains they earn on early stage investments. These provisions are in Sections 1202 and Sections 1045 of the tax code. 

I have been in the startup investing business for the entire time that these provisions have been in the tax code and to my knowledge, I have never taken advantage of them. So that tells you something, eiter about me or the provisions, or both.

However, given the increasing amount of angel investment activity in the startup sector, I thought it might be useful to post about these provisions, solicit comments and discussion about them, and maybe we all can learn something.

Let's start with the definition of Qualified Small Business Stock (QSBS). From this excellent post on the AICPA website:

To qualify as QSBS, the stock must be:

  • Issued by a domestic C corporation with no more than $50 million of gross assets at the time of issuance;
  • Issued by a corporation that uses at least 80% of its assets (by value) in an active trade or business, other than in certain personal services and types of businesses described in more detail below;
  • Issued after Aug. 10, 1993;
  • Held by a noncorporate taxpayer (meaning any taxpayer other than a corporation);
  • Acquired by the taxpayer on original issuance (there are exceptions to this rule); and
  • Held for more than six months to be eligible for a tax-free rollover under Sec. 1045 and more than five years to qualify for gain exclusion.

Sec 1045 allows a "tax-free rollover" which means that you can avoid paying the capital gains tax if the gain is "rolled over" meaning invested back into another QSSB. I believe that roll-over has to happen within six months of the gain, which is one of the many reasons I have not taken advantage of this provision. I like to take my time in making my investments and don't like having a ticking time bomb or gun at my head when doing so. 

Sec 1202 allows for an exclusion on the capital gains if the stock has been held for five years or more. I believe the exclusion is currently at 50%, but has been as high as 100% and there is also a 75% exclusion in some circumstances.

I agree with the Kid that tax loopholes and tax giveaways are generally a bad idea and I would personally prefer a simple flat tax with no trickery and gamesmanship. However, you have to live in the world you live in. And so if you are an angel investor, these provisions can provide great value to you.

One of the problems with these provisions is figuring out if you own QSSB, how long you have owned it, if you qualify for an exclusion or a rollover, and how quickly you need to do the rollover investing. They scream out for a platform to help angel investors with this stuff. Seems like a big opportunity for CircleUp, AngelList, and the other equity crowdfunding platforms. They can collect all of this data, build the logic into their systems, and alert angel investors when and if they can take advantage of these provisions. Maybe that would make it so that investors actually take advantage of these provisions. Maybe someday I will too.