QSBS 101

What is Qualified Small Business Stock (“QSBS”) and why does it matter for VC-backed startups?

QSBS refers to a tax benefit that can help investors in small businesses save up to $10M a year, or 10X your investment, in taxes, and is a very useful tax planning tool for venture capitalists and founders of technology startups.

Basic QSBS requirements are that the company needs to be a Delaware C-corp company. Additionally, it has to have less than $50 million in net assets on a tax basis. The startup must be in a hard science or innovation space, and the holder of the stock must own it for at least 5 years - those are the basic qualifications, although every company and shareholder is unique, so you’ll have to consult with a CPA to confirm that your stock holdings meet the requirements.

LLCs are NOT QSBS Eligible

At Kruze, as tax advisors to many startups, wee see so many companies coming to us who mistakenly incorporate as an LLC. This is usually because they are taking tax advice from a friend or family member who doesn’t understand the startup-tax landscape. To be QSBS eligible, a small business must be a C-Corp; LLCs are not eligible.

And if a startup is going to raise VC funding, it will have to convert to a Delaware C-Corp. VCs invest in Delaware C-corps because they’re not pass-through entities. That means like the gains or losses don’t hit the VC fund on an annual basis. They also know the case law in Delaware really well, which is well established for corporations of all sizes.

Do VCs care about QSBS?

Yes! Venture capitalists care about QSBS too, because the GPs in the fund can actually benefit from it. And while a lot of the limited partners in many venture capital funds tend to be non-tax paying foundations, endowments, the GPs are usually individuals, and they get the benefit from QSBS. 

And it’s one of the reasons you’ll see in a lot of funding documents, the legal docs will actually ask the startup to rep or warrant that QSBS is alive in the company at the time of investment. This is something that founders need to be a bit careful with, but it’s a good thing generally to do on behalf of your investors. 

Can a Company Convert from a LLC to C-Corp to Become QSBS Eligible?

We have seen a few instances where an expensive lawyer may be able to help an LLC convert into a C-Corp to become eligible for Qualified Small Business Stock. But we are not qualified to opine on that and strongly recommend you start your company as a Delaware C-corp. It’s not easy to do, very complicated.

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