DISCLAIMER: Things I am not: an accountant, a lawyer, a fiduciary to any reader, or a registered advisor. I’m just a guy writing a newsletter so none of this constitutes any tax, accounting, legal, life, or investment advice.

Following up from last week

Surprisingly received quite a bit positive feedback about last week’s roundup. If you enjoyed it or more important did not enjoy it, let me know. Feedback t’s the only way I can improve. I’m looking forward to creating more content to be “rounded up” in future months.

This week we come back to Numbers, for a focus on QSBS, Qualified Small Business Stock. QSBS is the magic that makes investing in venture capital one of the best opportunities for most family offices (vs institutional investors without taxation or pass through taxation). QSBS beats 1031 and Opportunity Zones and this will be your first primer on how and why.

Numbers
QSBS: Venture's Tax Free Law

What is QSBS? Qualified Small Business Stock is the single best tax advantage available to taxable entities in the United States. That’s obviously my opinion but I think when you read about it you’ll agree. We’ll cover QSBS at least a few times in the first year of this newsletter. It’s just that impactful to early stage returns, and has that much nuance that it warrants it. This episode is just a primer on why QSBS is amazing — we’ll get in to more of the details in follow ups.

Section 1202

Outside of the VC ecosystem you may hear QSBS referred to as “Section 1202”, which is the section of the tax code covering qualified small business stock. If you’re interested in reading it, I’ve linked a copy of it here. I think everyone should read it and also talk with their trusted accountants and lawyers because there is nuance and strategy.

Section 1202 is generally viewed as existing in order to encourage investment in domestic small businesses that contribute to the economy via manufacturing or technology. In 2010 congress passed the Creating Small Business Jobs Act of 2010. This overnight added steroids to a little known part of the tax code that had provided up to a 60% discount on federal capital gains tax if an investor jumped through a bunch of hoops. In 2010 the hoops were reduced and the reward was increased.

Tax Free*

Venture is a waiting game, with most funds offering fund cycles of 10+ years and, according to a panel I recently heard, the average fund taking 16-17 years to close down. This means that most, if not all, VC returns are long-term capital gains. Generally thats 20% plus whatever your state charges.

Thanks to Creating Small Business Jobs Act of 2010, for any QSBS business invested in to after 2010, the federal capital gains rate is 0%.

Yes you read that right - nothing.*

The Kicker

You can keep your winnings and not reinvest.

Unlike in 1031 Exchanges and many Opportunity Zone deals, you don’t have to reinvest the proceeds. You can take your money and buy a Rolls Royce or bury it in a hole in the ground to be retrieved by divine right by your great grandchildren.

You pay no tax and actually get to eat your cake instead of remixing it in to another slightly larger cake. Yes, I agree, a horrible analogy but I’m sticking with it.

*Limits Apply

Beyond the potential responsibility for paying state taxes, investors also have to keep in mind the limitations of QSBS. You “only” get $10 million dollars of gains, or 10x your initial cost basis, whichever is greater.

This leads to $100,000 investments being able to get as much as a 100x multiple tax free, saving up to $2 million dollars in federal capital gains tax liability.

However you may still also have to pay state taxes. Many states, including New York and Colorado, follow the Federal exemption meaning there is no taxation. However others like my home state of California still assess full state capital gains taxation to QSBS derived gains. Even at the 13.3% capital gains rate in California, the avoidance of the federal portion means just over a 60% reduction in total taxation.

The How

We’re going to focus on a lot more on the how and where the nuance exist in the next installment of Numbers: QSBS. However I’ll cover the absolute basics here. As with many things there’s additional nuance that will be covered in the future episodes.

There are four key tests for QSBS.