Entity Selection: How QSBS Could Save You Millions in Taxes

I often work with entrepreneurs starting new ventures. While there are multiple considerations for new businesses, the first important item to address is entity formation, governance, and finance/ownership.  This is the starting point to get your venture headed in the right direction.  

When choosing an entity type, there are certain considerations you should be contemplating at the onset. These include: 

1. Will I be seeking financing and, if so, will it be debt or equity? 
2. How do I want my entity to be treated for tax purposes? Will I be making regular distributions? 
3. Do I intend to offer my employees equity? 
4. What is my long-term goal/exit strategy? 

Your answers to these questions will be critical in selecting the correct entity to set your venture and your partners up for maximum benefit. Most typically, we advise entrepreneurs to start c-corps or LLCs, and in certain cases, to consider using qualified small business stock. For this purpose, I am going to focus on a fairly common model for a tech company. This means the following: 

1. The company will be seeking private equity investment. 
2. Moneys derived from operations will not regularly be issued as dividends or distributions and will be reinvested into company growth. 
3. The company would like to reserve an equity pool for key employees. 
4. Long term, the founders would like to sell the company. This exit will be the liquidity event that pays back investors and compensates employees for sweat equity. 

If the above sounds applicable to your venture, you would be wise to consider whether forming a c-corporation and issuing Qualified Small Business Stock is applicable to your business. 

What is Qualified Small Business Stock? 

Section 1202 of the Internal Revenue Code allows owners of small businesses to exclude all, or a portion of gains recognized from the sale of shares in a company from their income if (1) the stock is eligible to be treated as Qualified Small Business Stock; and (2) they have held such stock for 5 years or more. This is a significant tax incentive that can reduce your tax burden from 30+% of earnings to essentially zero. 

Eligibility 

In order to be eligible for QSBS treatment, the stock must be: 

• Issued by a US c-corporation having $50million or less in gross assets as of the date of stock issuance (and immediately following) 
• Acquired from the c-corporation in an original issuance (not purchased from an existing shareholder) 
• Issued by a company that uses at least 80% of its assets in the active conduct of a Qualified Business 

The IRS guidance defines Qualified Business in the negative. Essentially, Qualified Businesses are not: 

• Professional services (doctors, lawyers, accountants, architects, consultants, athletes, financial advisors, or brokers, etc.) 
• Businesses whose principal asset is reputation or skill (see above) 
• Banks, insurers, financers, leasers, investors, or similar service-based businesses 
• Farming businesses 
• Producers or extractors of natural resources 
• Hotels, motels, or similar businesses 
• Real estate investment operations 
• A Domestic International Sales Corporation (DISC- basically strictly exporting goods and making a special election for tax purposes) 
• A co-op 

Takeaways 

Selecting the appropriate entity at the onset of your business journey is critical to set your company up for success. If you are starting a business that you hope to sell/exit in more than five years, and your business in a Qualified Business, the tax incentives under section 1202 can be very compelling and you should strongly consider incorporating as a subchapter c-corporation.