Don’t Leave Money on the Table: QSBS Planning for Founders & Investors

For many startup founders, the dream of a successful exit is what drives years of hard work and risk-taking. Yet, when that moment finally arrives, many founders are not prepared for the web of tax rules that can have a massive impact on their ultimate payout. One of the most valuable but often misunderstood tax advantages available to founders and investors is the Qualified Small Business Stock (QSBS) exclusion, which can allow you to exclude up to $10 million (or 10x your investment) in capital gains from federal taxes.

In a recent panel discussion, Robbie Shattuck, founder of Athos, shared why early planning around QSBS is critical, the costly mistakes he sees founders make, and practical steps every entrepreneur should consider. This article will break down what QSBS is, why C corporation status is essential, and how founders can set themselves up to maximize this powerful tax benefit. For a quick summary of the panel’s key takeaways, check out our LinkedIn post here.

As Robbie emphasized, “a lot of it comes down to estate planning. When I work with the founder, I tell them it’s never too early to get started. You can’t afford to be reactive when the stakes are this high.” Far too often, founders miss out on significant tax savings because they wait too long or don’t have the right structure in place. Robbie noted, “If you don’t address these things up front—entity type, cap table structure, even something as basic as a clean separation between personal and business finances—you’re setting yourself up for headaches, or worse, leaving money on the table.”

What is QSBS?

Qualified Small Business Stock (QSBS) is a special type of stock issued by a C corporation that meets the requirements under Section 1202 of the Internal Revenue Code. If you qualify, you may be able to exclude up to $10 million or 10 times your original investment, whichever is greater, in capital gains from federal taxes when you sell your shares. These sales can happen in several ways, including secondary transactions, participation in a priced equity round, or during a liquidity event such as an acquisition, merger, or IPO. Taking advantage of the QSBS exclusion can mean million in tax savings for founders and early investors.

Why C Corporation Status Matters

To qualify for QSBS, your company must be a U.S. C corporation at the time the stock is issued and when it is sold. LLCs and S corporations do not qualify.
If you started as an LLC or S corp, you can convert to a C corp. However, only stock issued after conversion is eligible, and the five-year QSBS holding period starts from the date of conversion.

Practical Steps and Checklist for Founders to Consider

• Incorporate as a C Corporation early (or convert as soon as possible if you started as a pass-through entity)

• Track your company’s gross assets to stay under $50 million at stock issuance

• Ensure your business activity qualifies under IRS rules

• Acquire stock directly from the company (not from another shareholder)

• Hold your shares for at least five years

• Keep your cap table clean and well-documented

• Consult with tax and legal advisors regularly

Common Pitfalls

Robbie highlighted that simple missteps can cost founders dearly. For example, setting up as an LLC or S Corp instead of a C Corp can disqualify you from QSBS benefits. While a messy cap table won’t directly disqualify you, it can make it harder to verify eligibility and track share issuance, so it’s important to keep clear records. Other pitfalls that can jeopardize QSBS status include:

• Exceeding the $50 million asset limit before issuing stock

• Failing to meet the five-year holding period

• Selling company assets instead of stock (asset sales don’t qualify)

• Operating in a non-qualifying industry

Section 1045 Rollover

Founders should be aware of the Section 1045 rollover provision. This allows you to reinvest proceeds from the sale of QSBS (if held for less than five years) into new qualifying small business stock within 60 days. By doing so, you can defer capital gains taxes that would otherwise be due. This provision is useful for founders who have an exit before meeting the five-year holding requirement but plan to reinvest in another qualifying startup.

Basis Calculation

The exclusion cap limit is per taxpayer, not per company, and is based on the greater of $10 million or 10 times your original adjusted basis in the stock. For example, if you invested $500,000 in a startup, your exclusion cap would be $5 million (10x your investment) or $10 million, whichever is greater. In this case, it would be $10 million. However, if you invested $2 million, your cap would be $20 million (10x your investment).

Takeaway

Early, proactive planning is essential for founders and investors who want to maximize their after-tax exit proceeds. The best outcomes come from founders who plan ahead, understand QSBS, and set up their companies for success from day one.

Sources:

IRS Section 1202 Guidance (PDF)

Wilson Sonsini: Understanding Section 1202—The Qualified Small Business Stock Exemption

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