How Company Founders Can Maximize Tax Savings

For the founders of small private companies, understanding what Qualified Small Business Stock (QSBS) provisions are and how they work can be crucial for your financial strategy. Designed to incentivize investment in small businesses, QSBS is a type of stock that offers significant tax savings by allowing you and certain other shareholders to potentially exclude some capital gains from taxable income when selling shares.

However, navigating the eligibility criteria and strategic planning required to take advantage of these benefits can be complex. Here’s a starter guide to help you understand and maximize the potential of QSBS.

Understanding QSBS Eligibility for Companies

To qualify for QSBS under IRS criteria, your company must:

• Be registered as a U.S. C-corporation;  
• Have had aggregate gross assets of no more than $75 million at all times before and immediately after the issuance of shares; and  
• Have at least 80% of the value of its assets used in the active conduct of one or more qualified trades or businesses. Certain industries, such as financial services, fossil fuels and hospitality, among others, are not eligible for QSBS classification.

To maintain QSBS eligibility, the issuing company also must avoid certain actions. These include redeeming more than 5% of the total value of outstanding shares within two years of issuance, making illiquid investments or shifting the company’s business model to one that does not qualify.

Key Considerations for Shareholders

In addition to the IRS’s QSBS eligibility criteria for companies, there are also requirements for shareholders that you, your executives and other early-stage investors must understand. For example, shareholders must acquire the shares at original issue and hold them for at least five years to receive the full 100% capital gain exclusion. There are partial exclusions for shares held for three or four years, but aiming for the five-year mark can help achieve the maximum tax savings. 

Strategic Planning

For QSBS shareholders, one key strategy to potentially boost federal income tax savings is known as “stacking,” which involves spreading the QSBS exclusion across multiple taxpayers. The lifetime exclusion limit for each taxpayer is $15 million—an expansion under the One Big Beautiful Bill Act from the previous $10 million—or 10 times the investor’s adjusted “basis” (typically the investment’s purchase price)—depending on when the stock was issued. These taxpayers can include non-spouse individuals such as children, non-grantor trusts or estates, allowing for multiple exclusions and potentially increasing overall tax savings.

Other strategies to limit taxable capital gains include making 83(b) elections on certain restricted stock awards (RSAs), exercising options early and pursuing alternative liquidity strategies. It is crucial to verify eligibility and consult with certified tax planners to minimize audit risks and ensure compliance with IRS regulations.

QSBS Strategies In Action

Here’s a hypothetical example: A founder, Jane, is granted two million shares through her company’s equity compensation plan. These shares eventually gain $50 million in value. If they are not QSBS shares, their sale could potentially trigger $11.9 million in capital gains taxes if she sells the full amount.¹ If they are QSBS shares, however, Jane can exclude $15 million from their sale for tax purposes, resulting in a potential $8.3 million in taxes on the remaining proceeds, translating into a $3.6 million tax savings.

Now imagine Jane gifts one million of her QSBS shares to two trusts, one for each of her children as beneficiaries. Jane’s proceeds on the sale of her remaining one million shares are now $25 million, potentially resulting in $2.4 million in taxes after applying the exclusion. Meanwhile, the two $12.5 million in gifts for each of the trusts would not trigger any taxes, as they are both below the full exclusion amount. Alternatively, if Jane split the two million shares evenly between herself and the two trusts, the total tax obligation could potentially be as low as $1.2 million.

Taking the Next Steps

QSBS may provide a powerful tool for founders and early-stage investors to achieve substantial tax savings. However, navigating the eligibility criteria, strategic planning and legislative changes requires careful attention and expertise.

Work with your Morgan Stanley Financial Advisor to understand key considerations and strategies appropriate for your specific needs in order to maximize potential QSBS benefits. Work closely with your attorneys, tax advisors and financial planners to ensure that QSBS plans are structured appropriately and aligned with long-term goals.

To learn more, ask your Financial Advisor or Morgan Stanley representative for a copy of the Global Investment Office report, “A Guide to QSBS: How Qualified Small Business Stock Can Create Tax Savings.”