By selling ZoomShift through qualified small business stock (QSBS), Haintock was able to take advantage of an exemption in the tax code designed to save founders like him money.

“[QSBS is] an important thing to consider if you’re starting something new,” Hainstock told They Got Acquired founder Alexis Grant in a podcast interview. “If you think you might be able to get to an exit like that, QSBS could end up saving you a lot of money.”

What we’ll cover in this story:

• What is QSBS?
• QSBS requirements (to figure out if you qualify)
• QSBS holding period
• QSBS tax rate
• When a QSBS sale makes sense for your business
• Why some buyers don’t like C corps
• QSBS checklist: preparing for a future sale

What is QSBS?

QSBS stands for qualified small business stock, a share of a company that comes with federal tax benefits.Under the Internal Revenue Code — U.S. tax law — sales of shares in qualified businesses are exempt from capital gains taxes. Those can be significant, up to 20% in 2021.

Section 1202 of the tax code carves out the QSBS exemption, defining a qualified business as a domestic C corporation with $50 million or less in assets.

In short? The QSBS exemption is a way for certain small business owners, employees and investors to sell all or part of a business with potentially massive tax savings.

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Does a QSBS sale make sense for your business?

The potential for significant tax savings makes the QSBS tax exemption an exciting prospect for founders looking to sell. Yet, most sales for small businesses are still asset sales, not equity sales.

Alicia Goodrow, an M&A attorney with Culhane Meadows who works with owner-managed private companies, says that’s because Section 1202 isn’t a good fit for most companies.

As Goodrow explains it, Section 1202 was written in the wake of The Great Recession as an incentive for investors to put money into small businesses — with hopes of recapturing the kind of energy we saw in the economy during the dot-com boom of the late 90s. The carve-out favors tech companies that are built to sell relatively quickly.

In the dot-com era of building tech companies, VCs got in, because “there was cash at the end of the rainbow,” Goodrow says. “And the rainbow was really short.”

Most companies don’t operate that way, she says. If you’re starting a company with the intent to operate it, even if you’re open to selling at some point, structuring with QSBS in mind could add unnecessary bumps in the road.

The C corp requirement, Goodrow points out, could be prohibitively onerous for some small companies outside the tech sphere. Corporate formalities like annual meetings, electing a board or ratifying an annual report are particular and easy to mess up, which opens you up to legal issues a small company probably isn’t equipped to manage.

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Why some buyers don’t like acquiring C corps

Outside of Silicon Valley, Goodrow said most buyers she encounters are looking for LLCs.

“C corps are bad tasting to P.E. [private equity] groups and roll ups and other groups that are structured as pass-through structures. They don’t want to buy equity,” Goodrow explained, referring to C Corps.

Stock deals for small companies are usually less attractive to buyers, whose long-term tax strategy revolves around a portfolio of LLCs.

If you’ve structured your company and exit plan around a QSBS sale and run into a buyer who was hoping for an asset sale, be willing to negotiate, Karachale said.

“Buyers traditionally, maybe in the middle market, want to do asset sales, but that’s just a negotiating point,” he said. Because of the massive tax savings for QSBS, you have a lot of room to adjust your price to make a stock sale more attractive to a buyer and still come out ahead.

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2. Form a C corp in the United States

To be a qualified small business, your company needs to be a U.S.-based C corporation as recognized by the IRS.

Other business entities are ineligible, so if you currently operate as a sole proprietorship, partnership or LLC, work with a legal expert to take the next step to incorporate.

Unless you know you’re building to sell from the beginning — and have a clear path to exit — Goodrow recommended structuring your business as an LLC to start. You can always shift gears later and restructure into a C corp if you see a future path to a QSBS sale, but you can’t restructure a C corp into an LLC if you discover that’s your best option.

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‘Begin with the end in mind’

Although Goodrow doesn’t work with companies built with quick exits in mind, she does help founders keep in top shape for a potential sale. She checks in with companies at least a couple of times a year to adjust to their goals — whether that’s raising money, selling the company or anything in between.

“I’m a big believer [that we] begin with the end in mind,” Goodrow says. “Beginning with the end in mind is really about defining what their goals are early.”

Karachale and Goodrow both cautioned not to get so caught up in potential tax implications that you don’t make the best moves for your company. 

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That is, if you’re faced with a good opportunity to sell but you haven’t had five years to prepare for a QSBS sale, an asset sale could be a better move than waiting just to get the tax break. You may not want to operate the business for another several years — and buyers might not be willing to wait, either.

We’re reporters, not financial advisors. If you need help with financial decisions, please hire a finance professional. The information contained in this piece is provided for informational purposes only, and should not be construed as financial advice.