How to expand a successful tax incentive

Qualified small business stock (QSBS) is a type of equity that receives special tax treatment upon liquidation if certain conditions are met by the company and the shareholder. Congress created QSBS under Section 1202 of the Internal Revenue Code in 1993 to stimulate investment in innovative companies that were beginning to emerge from the modern venture-backed startup sector.

History of QSBS

After establishing QSBS in 1993, Congress has twice amended the exclusion to enhance its utility. In 2009, Congress increased the percentage of gains excluded from 50% to 75%. And in 2010, Congress again raised the percentage to 100%.

Thus, depending on the year the shares were issued, QSBS allows the shareholder—whether it’s a founder, investor, or employee—to exclude 50%, 75%, or 100% of the capital gains resulting from the sale of their shares. 

QSBS criteria

To qualify for QSBS tax treatment, the shares must be:

• Issued by a U.S. C-corp with <$50 million in gross assets 

• Issued by a company operating in a qualified trade or business

• Acquired directly from the company

• Held for at least five years prior to liquidation

The capital gains exclusion amount on QSBS varies according to the year the shares were issued:

The limit on QSBS exclusion is $10 million or 10 times the investor’s cost basis, whichever is greater. Either way, the limit is on a per-company basis, which means that an investor with capital gains resulting from two separate qualifying companies could exclude up to $10 million in capital gains (or 10x the cost basis) for each investment.

How does QSBS incentivize investment in small businesses? 

Most small businesses fail. According to the Bureau of Labor Statistics, about 20% of small businesses fail within a year, 31% fail within two years, 49% fail within five years, and 65% fail within a decade. 

In the tech sector, the failure rate is higher than average. The “information” business classification has the second-highest failure in the private sector:

The Harvard Business Review reports that two-thirds of startups close up shop without ever delivering a cent back to their investors. This makes startup investment inherently a high-risk proposition. Investors take the risk because they know that when an innovative startup succeeds, it can sometimes return 10x their initial investment, or more. 

QSBS also helps fledgling startups attract talent. Like founders, who often leave lucrative positions in larger firms to start their own companies, top talent has a choice: Employees can work for an established corporation, where the risk of failure is low, resources are abundant, and their equity compensation is publicly traded stock. Or they can take a chance to help a startup tackle an ambitious opportunity. Often, the incentive to make the leap is the startup’s equity award, which could grow exponentially in value if the company succeeds. QSBS further sweetens the deal and helps founders attract talent with the potential of tax-free equity earnings.

Who benefits from QSBS?

Founders, early-stage investors, and a company’s early employees all benefit from QSBS, because any stock issued while the company remains under the $50 million gross asset threshold will qualify. 

Looking across Carta’s database of 45,000 privately held companies, we see that investors have the largest holdings in QSBS, at about 55%; this is expected, as they’re the ones who supply the businesses with capital. Founders and employees combine to own the other approximately 45% of the QSBS on the Carta platform that meets the five-year holding requirement. 

As the startup economy has grown, so too has the number of employees earning QSBS:

While some of the growth in employee QSBS equity ownership on Carta is due to the increase in companies using Carta for cap table management (and thus the increasing size of our database), the overall growth of the venture-backed startup ecosystem during this period created many more QSBS employee shareholders.

Which regions benefit the most from QSBS?

Unsurprisingly, owners of QSBS are clustered in states that have established venture hubs, such as California, New York, Massachusetts, Washington, Colorado, Utah Texas, and Florida, as well as Maryland and Virginia, which border the hub centered in Washington, D.C.

These regions not only contain a higher number of qualifying C-corporations; they also have dense networks of accredited investors. This increases the pool of locally available capital for early-stage investment, which is often sourced from individual angel investors rather than venture capital firms. 

QSBS earnings, in fact, can help to create additional angels, creating a virtuous cycle that leads to flourishing local startup ecosystems. 

How to enhance QSBS 

Although more employee-owners hold QSBS every year, QSBS still typically benefits only employees at the earliest stages. The $50 million gross assets threshold has not altered since Congress enacted Section 1202, which means its utility will slowly erode with inflation and the rising costs of doing business. Moreover, businesses with very high capital intensity will more quickly pass the threshold. 

To allow more employees to benefit from this tax incentive, Congress could raise the threshold for what counts as a “small business” from $50 million in gross assets to $100 million or $150 million.

Carta data shows that increasing the threshold to $150 million in gross assets would increase ownership by approximately 10% among investors, advisors, board members and other equity holders, while boosting the number of employee QSBS owners by more than 40%.

To ensure the U.S.remains at the leading edge of the global tech and innovation economy, and to continue to foster entrepreneurship and job creation, we should preserve and expand qualified small business stock treatment. 

Carta supports:

• Maintaining the current 100% exclusion on QSBS

• Elevating the gross asset threshold for QSBS qualification to $150 million

• Expanding the QSBS benefit to include business entities other than C-corps, such as LLCs

• Clarifying that key financing arrangements such as convertible notes and Simple Agreement for Future Equity (SAFEs) are eligible for QSBS

Learn more: Qualified small business stock: Issue brief

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