The majority of start-up employees are overpaying taxes by not correctly applying the qualified small-business stock deduction. If stocks were a part of your compensation package, you might be able to cash in, tax-free!
What is the “Qualified Small-Business Stock” Tax Deduction?
Start-ups typically include stock options as part of new employee compensation packages. In the beginning, they’re worth pennies. However, when companies strike gold, through the magical power of market forces, those stocks can turn into millions overnight.
When holders sell stocks, many taxpayers incorrectly assume they need to pay capital gains tax. But Section 1202 of the Internal Revenue Code (IRC) says that if you’re a founder, investor, or employee of a successful start-up you may be able to avoid paying federal taxes on up to $10 million (or 10 times your cost basis, whichever is greater) of capital gains.
Start-up tax fact: Early employees can cash in their stocks and not pay any tax on the gains! The deduction applies to people who:
- Received shares from a domestic C corporation;
- When the company’s assets were less than $50 million;
- The company “makes something”;
- Held the stock for more than five years; and
- The entity is actively running. At least 80% of other assets must be in use and not held for investment purposes.
People who meet all four criteria can deduct either $10 million or 10X their investment, whichever is more.
When You Received the Stock Matters Most
Apparently, some people mistakenly believe that if a stock rises in value, then it becomes ineligible for the deduction. In fact, the stocks sale value isn’t a factor. What matters is the stock’s value when you received it and if the company’s total assets were under $50 million at that time.
For example: Let’s say “Amy” was LinkedIn’s fifth employee. As compensation, she received a salary and a generous stock package. Amy toiled away for ten years at the company and didn’t touch her stocks. However, when it hit $45, she cashed in for millions.
Since Amy received her stocks when LinkedIn was a fledgling startup, she’s eligible for the qualified small-business stock tax deduction. If she had come on board when the company was worth $75 million, however, she wouldn’t be eligible.
What Qualifies as a “Company That Makes Something”?
The first criteria hurdle for the qualified small-business stock tax deduction is company classification. It only applies to people who work for businesses that make something. Stockholders in service companies, like law firms and consultancies, cannot use this strategy. It also doesn’t apply to banking, insurance, or financial companies; farming; mining; nor operating hotels, restaurants or similar businesses.
Here’s the good news: Most tech companies make apps and platforms and other digital do-dads, so they typically cut the muster.
Qualified Taxpayer Beware: Audit Risk
The one drawback of the qualified small-business stock deduction is the risk of audit. If you did not originally claim the deduction, you can amend your tax return to do so.
Beware: a higher percentage of taxpayers who amend their returns to claim the credit get audited.
The upside: If you properly claim the deduction, you should come through the audit clean and receive potentially large refunds for the over-payment. Just make sure you work with a tax attorney to ensure you qualify!
Speak with a Startup Tax Lawyer about Strategies That Keep Money in Your Hands Instead of Uncle Sam’s
Over the past decade, capital gains rates have increased, making the qualified small-business stock tax deduction a better money-saving strategy for people who meet the criteria. Let’s talk about whether or not it can work for you.
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