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Unfortunately, there’s no straight answer to this. It will depend on where the acquirer is located, what industry you are in, the details of you own personal tax situation, and a myriad of other factors. You’ll want to consult with a CPA that specializes in startup taxation, as any advisory services will be tailored to your unique situation. The guidance will pay for itself many times over and is worth the investment.
Qualified Small Business Stock (QSBS) Exemption - A Federal Tax Break that California Startups Should Consider
One key tax benefit to consider when selling your California startup is the Qualified Small Business Stock (QSBS) exemption. This is a federal provision, not a California state one, and it’s outlined in Section 1202 of the Internal Revenue Code. It allows founders and early investors to potentially exclude up to $10 million or 10 times their original investment (whichever is greater) from federal capital gains taxes when selling their shares. That’s potentially a lot!
To qualify for the QSBS exemption, your startup must meet several criteria, including:
- Being a C-corporation
- Having gross assets of $50 million or less at the time of and immediately after stock issuance
- Using at least 80% of its assets in an active, qualified trade or business
- Holding the stock for at least five years before selling
- Several other minor provisions - that are easy to trip up and fail!
If your startup - and the shareholders - meets these requirements, the QSBS exemption can significantly reduce your tax burden when selling your company. It’s essential to work with a CPA who thoroughly understands the QSBS rules to ensure you’re maximizing this valuable tax benefit.
Does California Have a QSBS Provision?
While the federal QSBS rules under Section 1202 of the Internal Revenue Code allow for significant tax exclusions on gains from the sale of QSBS, California has its own set of rules and does not conform to the federal guidelines. In 2012, the California Court of Appeal ruled that certain provisions of the California QSBS statute were unconstitutional, leading the California Franchise Tax Board (FTB) to declare the entire statute invalid and unenforceable for tax years beginning on or after January 1, 2008. Consequently, California repealed its QSBS tax exclusion provisions in 2013, and all capital gains, including those from QSBS, are now taxed at the same rate as ordinary income in California. This means that gains from the sale of QSBS are subject to California’s high state income tax rates, which can go up to 13.3%.
So, basically, California startups may be able to minimize or reduce federal capital gains at an exit, but the state is still going to expect to get paid.
Feel free to reach out to me (Kruze Consulting) if you need any help: I’m a CPA and I help over 800+ startups. In the past I’ve worked at Deloitte Tax and was the Controller of a 120+ employee startup. Our COO Scott Orn is a Kellogg MBA, former VC Partner at Lighthouse Capital Partners, and before that was an investment banker at JPMorgan. We have one of the largest tax teams focused on startups, and our clients are two times as likely to be acquired as the average startup.
