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QSBS Playbook On Deck — Save Millions When You Sell Your Startup · MaxValue Podcast

• 0:11
  SPEAKER_01: All righty.
• 0:11
  SPEAKER_01: Well, man, I am happy to have you talking with me, me talking with you.
• 0:16
  SPEAKER_01: Uh my name is Ben Town.
• 0:18
  SPEAKER_01: Uh I run Town Advisory, a business valuation firm, and I have friends all over the place.
• 0:23
  SPEAKER_01: And one of the great ones is Gary Whitfield.
• 0:26
  SPEAKER_01: Uh Gary, why don't you introduce yourself and tell us what we're talking about?
• 0:30
  SPEAKER_00: Yeah, thank you, Ben.
• 0:31
  SPEAKER_00: Great, great to be with you today.
• 0:33
  SPEAKER_00: Um yeah, I'm Gary Whitfield.
• 0:36
  SPEAKER_00: Um I have a wealth management practice and a strategic consulting practice called Paraclete Wealth Partners, is the wealth management practice, and Paraclete Strategic Consulting is the consulting practice.
• 0:50
  SPEAKER_00: Uh, I have a master's in taxation, and I um and I'm the chief strategist for two family offices.
• 0:57
  SPEAKER_00: And today um we're gonna be talking about Ben, from what I understand, we're gonna take a walk down the qualified small business stock road.
• 1:07
  SPEAKER_01: Great.
• 1:07
  SPEAKER_01: Qualified small business stock.
• 1:09
  SPEAKER_01: That's kind of a mouthful.
• 1:10
  SPEAKER_01: How do you pronounce that?
• 1:12
  SPEAKER_01: Is that quizbiz?
• 1:13
  SPEAKER_01: Is it QIS quiz?
• 1:14
  SPEAKER_01: How do you say it?
• 1:15
  SPEAKER_00: QSBS, qualified small business stock.
• 1:18
  SPEAKER_01: QSBS.
• 1:19
  SPEAKER_01: I'm joking.
• 1:20
  SPEAKER_01: Okay.
• 1:21
  SPEAKER_01: Um, but okay.
• 1:22
  SPEAKER_01: Good getting into it though.
• 1:24
  SPEAKER_01: That's the same as our uh internal revenue code section 1202.
• 1:29
  SPEAKER_01: Uh why should we be excited about that?
• 1:31
  SPEAKER_00: Yeah, that's right.
• 1:32
  SPEAKER_00: It's it's section 1202.
• 1:34
  SPEAKER_00: And what 1202 provides Ben for really more than 30 years is it provides investors um an opportunity to shield up to$10 million of capital gain or 10 times their basis upon the disposition of their stock or their investment, uh, whichever is higher, right?
• 1:54
  SPEAKER_00: So a$10 million capital gain exclusion on the sale of your stock is a pretty good deal.
• 1:59
  SPEAKER_01: Right, right.
• 2:00
  SPEAKER_01: And so who is this for?
• 2:03
  SPEAKER_01: Uh I mean, I and everybody else have heard you know tech bros sitting around talking about this and they are all very excited about it.
• 2:12
  SPEAKER_01: Um, but do you have to be part of the you know puffer jacket crowd to take advantage of QSPS?
• 2:18
  SPEAKER_00: Uh well thankfully you don't.
• 2:21
  SPEAKER_00: Um, but typically, you know, there there's a couple of uh requirements.
• 2:26
  SPEAKER_00: As an individual, right, to take advantage, you want to be an individual um and you you want to be able to own the stock either outright or through a flow-through entity like an LLC, right, or an S-corp, um, or a certain, you know, revocable trust and certain types of other trusts.
• 2:45
  SPEAKER_00: Um, but generally to get the benefits, you want to be one of those, uh, one of those entities or structures.
• 2:51
  SPEAKER_00: And the point is so that you can get the benefit of the flow through of the character of the capital gain flowing through to you.
• 3:00
  SPEAKER_01: Okay.
• 3:00
  SPEAKER_01: And and that's that's for any business and any business owner, generally speaking.
• 3:04
  SPEAKER_01: I mean, it's it's a broad range, right?
• 3:06
  SPEAKER_01: Not just a uh a high-tech startup, for example.
• 3:10
  SPEAKER_00: No, that's that that's right.
• 3:12
  SPEAKER_00: So um there's generally four or five you know main requirements, right?
• 3:16
  SPEAKER_00: So um typically a qualified trader business, it's easier to define what's not a qualified trader business for purposes of qualifying for this this great capital gain exclusion.
• 3:29
  SPEAKER_00: So one of the ways to think about it, Ben, is generally professional per personal service corporations or personal service businesses don't qualify.
• 3:40
  SPEAKER_00: So, like if you're uh a CPA or a lawyer or a doctor, architect, actuary, anything that provides a or necessitates a professional license to practice, generally you're not going to qualify.
• 3:56
  SPEAKER_00: Um, but farming doesn't qualify, uh, mining and exploration and production doesn't uh apply.
• 4:03
  SPEAKER_00: And um, you know, banking and finance companies typically don't apply.
• 4:08
  SPEAKER_00: So most of the rest of the what's left over does apply.
• 4:12
  SPEAKER_01: So you're saying that a manufacturing company uh would qualify, you know, that uh uh given big enough uh sales, I guess, a a plumber would qualify those sorts of things?
• 4:25
  SPEAKER_00: Yeah, so certainly the the uh manufacturing company qualifies, um, you know, a a a plumber or uh depending on how much of his business was was providing you know parts and and process and and so a plumber might apply, might not.
• 4:45
  SPEAKER_00: Um, but generally speaking, if you're in a trader business that's non-specifically professional services, you're gonna qualify.
• 4:56
  SPEAKER_01: So basically, what you're telling me is that neither one of our businesses are gonna qualify, but many of our clients is will.
• 5:03
  SPEAKER_00: Yeah, almost every one of your clients, Ben, is gonna qualify, but you and I won't.
• 5:08
  SPEAKER_01: Great.
• 5:08
  SPEAKER_01: That's that's great news for my clients.
• 5:12
  SPEAKER_01: Well, we'll talk me through the the rest of uh the the hurdles for QSBS.
• 5:16
  SPEAKER_01: I mean, what are the other requirements that people need to have in order to just take advantage of this really great exit?
• 5:22
  SPEAKER_00: Yeah, you know what?
• 5:23
  SPEAKER_00: That that's a great question.
• 5:25
  SPEAKER_00: And it's and it's really it's fairly simple.
• 5:27
  SPEAKER_00: You have to have qualifying trader business, which we talked about.
• 5:31
  SPEAKER_00: Um, original issuance of that business has to be C corporation stock, right?
• 5:39
  SPEAKER_00: So right entity, a C Corp qualifying trader business.
• 5:43
  SPEAKER_00: Now, upon the issuance of that stock, if the assets or the value of that business is below 50 million, right?
• 5:51
  SPEAKER_00: That's good.
• 5:52
  SPEAKER_00: So assets below 50 million, right?
• 5:55
  SPEAKER_00: And then you have a five-year holding period for the stock.
• 6:00
  SPEAKER_00: So if you meet qualifying trader business, original issuance from a C Corp, and less than 50 million of uh valuation of that business upon the issuance of that stock, your next major hurdle is the five-year period.
• 6:16
  SPEAKER_00: So if you held that stock for five years in a day, then you qualify for that$10 million exclusion or 10 times your basis, if 10 times your basis is higher than 10 million.
• 6:28
  SPEAKER_01: Awesome, right.
• 6:30
  SPEAKER_01: And you said the magic word value valuation.
• 6:33
  SPEAKER_01: Uh that's where we cross over on this on this topic.
• 6:36
  SPEAKER_01: So uh love working on that.
• 6:38
  SPEAKER_01: I mean, and this is something that uh the QSBS, this is something that you guys have actually at your firm helped uh business owners use in their exit planning, right?
• 6:47
  SPEAKER_00: Oh, absolutely, absolutely.
• 6:49
  SPEAKER_00: There's a lot of qualifying businesses out there um that are below an enterprise value of 50 million.
• 6:57
  SPEAKER_00: Some of them are operating as um LLCs or operating as S-corps, and those don't qualify, but their business qualifies.
• 7:05
  SPEAKER_00: So um we've done a lot of uh consulting work on reorganizing the business in a way that will start the clock ticking on a um qualified trader business, but there's usually a reorganization to get that C Corp stock issued.
• 7:24
  SPEAKER_01: Right, right.
• 7:25
  SPEAKER_01: Gotcha.
• 7:26
  SPEAKER_01: So obviously, we're talking about federal taxes here with talking about IRS, therefore the federal level.
• 7:32
  SPEAKER_01: Is there anything we can do for the state level taxes?
• 7:35
  SPEAKER_00: Yeah, most of the states um recognize uh 1202 capital gain exclusion.
• 7:41
  SPEAKER_00: There's six, five states and um a U.S.
• 7:45
  SPEAKER_00: jurisdiction that doesn't.
• 7:46
  SPEAKER_00: So California doesn't recognize it.
• 7:49
  SPEAKER_00: Um Alabama, Pennsylvania, uh New Jersey, um, Puerto Rico, and one other don't don't recognize 1202, but pretty much you know, 44, 43, 44 other states do.
• 8:06
  SPEAKER_01: Gotcha.
• 8:07
  SPEAKER_00: So you get the federal benefit, but when you go to file your California tax return, they recognize the entire game.
• 8:15
  SPEAKER_00: So there's a state federal um adjustment uh on on the California Form 540.
• 8:23
  SPEAKER_01: Great.
• 8:24
  SPEAKER_01: That's usual.
• 8:26
  SPEAKER_01: Why don't we uh I I think you've gone through uh you know most of the highlights, but uh obviously this is a very complex topic.
• 8:33
  SPEAKER_01: Uh why don't we dive into a couple of the of the details in kind of lightning round?
• 8:39
  SPEAKER_01: Uh and you know, maybe take 60 seconds or less to respond to each one and we'll kind of just get it and get some of the interesting stuff out there without you know getting like way too far into the weeds.
• 8:48
  SPEAKER_00: Right.
• 8:49
  SPEAKER_01: Okay, great.
• 8:50
  SPEAKER_01: Ready?
• 8:51
  SPEAKER_00: Absolutely, fire away.
• 8:54
  SPEAKER_01: So what's the deal with original issuance?
• 8:56
  SPEAKER_01: If I get stock from another investor, am I out of the QSPS club?
• 9:02
  SPEAKER_00: Um, well, if you acquire your stock from another individual through a purchase, that disqualifies because that's not original issuance.
• 9:12
  SPEAKER_00: But the good news there is that a gift, right?
• 9:15
  SPEAKER_00: If if somebody gifts you stock like a parent gifts it to um a son or a daughter, right, that gift is not disqualified from the original issuance um rule.
• 9:28
  SPEAKER_00: So gifting, yes.
• 9:30
  SPEAKER_00: Purchasing the stock from another person, no, that's disqualifying.
• 9:35
  SPEAKER_01: Gotcha.
• 9:36
  SPEAKER_01: And anytime you want to gift me any stock, I'm here for you.
• 9:40
  SPEAKER_01: So thank you.
• 9:40
  SPEAKER_00: Yeah, you know, and vice versa.
• 9:41
  SPEAKER_00: I'm I'm open to it.
• 9:43
  SPEAKER_00: All those clients that you consult, many of them are qualifying businesses, right?
• 9:48
  SPEAKER_00: And could very well get this QSBS benefit.
• 9:51
  SPEAKER_00: So I'm I'm ready.
• 9:53
  SPEAKER_01: All the time.
• 9:55
  SPEAKER_01: One of the key points is that it's a C Corp that that applies, uh, that 1202 applies to.
• 10:01
  SPEAKER_01: Um, well, what happens if I have an LLC?
• 10:05
  SPEAKER_01: You know, how can I turn that Sousier into a uh silk purse here?
• 10:09
  SPEAKER_00: Yeah, and you know, this this may take just slightly over 60 seconds, but that's the big uh that's the big benefit, right?
• 10:16
  SPEAKER_00: Because most of these tech companies out here in Silicon Valley, and you don't have to be a tech company, as you as we mentioned, you can be an operating trader business and get this benefit.
• 10:25
  SPEAKER_00: But you know, Ben, a lot of your clients they'll rush off to Delaware, they'll incorporate a C Corp.
• 10:32
  SPEAKER_00: And when you incorporate a new company, typically you have very low basis in your stock.
• 10:38
  SPEAKER_00: You're either dropping in an intangible or know-how with little or no basis, maybe some cash.
• 10:44
  SPEAKER_00: So what you drop in in exchange is the basis in your stock.
• 10:50
  SPEAKER_00: But to your point, if you start as an LLC, right, and your LLC, which, yeah, I just told you an LLC is a disqualifying entity.
• 11:00
  SPEAKER_00: But let's say you have an LLC and you're perfecting your, you know, you're not a uh minimally viable product, you're not an MVP yet, and maybe you're in a beta proving ground, right?
• 11:14
  SPEAKER_00: Um, and so you're operating as an LLC, and then you go now for the A round because you're pre-MVP status, right, or you're about to prove out your beta and you're gonna go for an institutional round.
• 11:26
  SPEAKER_00: If you're an LLC, right, and you're and you raise funding and the venture capital firm drops in$10 million, for instance, in exchange for one third of the company, and you, as the business owner in the LLC, you and your partner drop in your entire LLC units in exchange for stock.
• 11:46
  SPEAKER_00: What you just did right there, if the VC put in$10 million for one third of the business, and that value is$10 million, what's the value of your LLC that you dropped in on an arm's length transaction in exchange for that C Corp stock?
• 12:02
  SPEAKER_00: The answer to that is$20 million.
• 12:04
  SPEAKER_00: So 20 million times 10, you just created a$200 million capital gain exclusion.
• 12:11
  SPEAKER_00: And all you did is you started as an LLC first, proved out your, you know, your beta round or got to a pre-MVP minimally viable product scenario, and then you went out for that A round of funding, right?
• 12:26
  SPEAKER_00: So that$1202 allows you to take as your basis for calculating your 1202 exclusion the value of your property upon formation of that C Corp stock that was issued to you.
• 12:40
  SPEAKER_00: So in that example,$20 million was the value of your LLC interests, and you traded those for newly issued C Corp stock, your clock starts ticking, and you went from having a$10 million opportunity to a$200 million capital gain opportunity exclusion.
• 12:57
  SPEAKER_00: Does that make sense?
• 12:59
  SPEAKER_01: Absolutely.
• 12:59
  SPEAKER_01: And I and I think one of the important things there is that you have to have the foresight to do this in advance, five years in advance of an exit.
• 13:08
  SPEAKER_01: So anybody who's thinking, gosh, I really want to get out of my business this year or next year, either this is not for you, or this is something that you really have to consider.
• 13:18
  SPEAKER_01: Hey, is it is it worth the the five-year time frame, that kind of thing.
• 13:22
  SPEAKER_00: Yeah, that's right.
• 13:23
  SPEAKER_00: That's right.
• 13:24
  SPEAKER_00: And then to your other point about an LLC, and let's say that you're not you you have an operating trader business that's an LLC, you're not going to get additional funding, right?
• 13:35
  SPEAKER_00: Right.
• 13:35
  SPEAKER_00: What you can do, and this applies to a lot of operating trader businesses that just aren't the right structure, they're not C Corps.
• 13:43
  SPEAKER_00: They could come see you, say, hey, Ben, we want to convert to a C Corp.
• 13:48
  SPEAKER_00: We need you to value our business, right?
• 13:51
  SPEAKER_00: Because we're going to drop either the LLC units or if it's an S-corp, we're going to drop the assets of the S-Corp into a newly formed wholly owned subsidiary in exchange for that stock.
• 14:03
  SPEAKER_00: Well, they're going to need a valuation because the valuation is critical to make sure that at the time of formation there is a valid appraisal done on that business.
• 14:13
  SPEAKER_00: And now all those other non-tech business, non-venture capital funded businesses can convert, get that C corporation original issuance and have that appraisal in their back pocket to basically um stand behind the valuation at the time of that subsidiary formation.
• 14:34
  SPEAKER_00: And that's going to give them the basically the backup that they need to get in that example, that$200 million capital gain exclusion.
• 14:46
  SPEAKER_01: Thank you.
• 14:47
  SPEAKER_01: So can you break down the gross assets rule in a way that even my seventh grader can understand it?
• 14:55
  SPEAKER_00: Yeah, you know what, then there's there is some consternation that people have with that, but but generally speaking, right, there's really two gross asset rules.
• 15:04
  SPEAKER_00: Upon formation, you just want to be worth less than$50 million on a pre and post-money valuation, right?
• 15:13
  SPEAKER_00: So as long as the value of your business is below$50 million on the date you reorganize into a C corporation, you're fine, right?
• 15:22
  SPEAKER_00: You don't want to be$50 million or higher because that excludes the benefit, right?
• 15:30
  SPEAKER_00: So it's the so the the the guidepost is assets or enterprise value less than 50 million upon formation.
• 15:40
  SPEAKER_00: You're you're usually you're usually good.
• 15:43
  SPEAKER_00: Um the other asset test that a lot of people worry about is you gotta make sure that 80% or more of the assets are used in that specific trader business.
• 15:54
  SPEAKER_00: And all that's saying, Ben, is hey, I'm going to um my working capital or my excess cash is for the trader business that I'm operating in.
• 16:08
  SPEAKER_00: They just want to make sure that you're not going off and investing in unrelated real estate or unrelated public market investing or unrelated businesses.
• 16:16
  SPEAKER_00: So you want to make sure that at least 80% of your assets or more are for this qualifying trader business.
• 16:24
  SPEAKER_01: Thank you.
• 16:25
  SPEAKER_01: So one other kind of detail-y question.
• 16:28
  SPEAKER_01: I mean, I you know, I've heard about you know a stacking strategy, um, you know, it involving you know gifting and multiplying the tax savings.
• 16:35
  SPEAKER_01: Can you talk to me about that and tell me what that's about?
• 16:39
  SPEAKER_00: Yeah, so Ben, that's that's that's a great question.
• 16:41
  SPEAKER_00: You'll recall that we said, hey, when you acquire the stock, it has to be from an original issuance, right?
• 16:48
  SPEAKER_00: So somebody can't buy the stock from another individual, it has to come directly from the company.
• 16:54
  SPEAKER_00: One of the exceptions to that, though, is if you are gifted stock.
• 16:58
  SPEAKER_00: And it it's it's not uncommon for um an entrepreneur or the a married couple to begin gifting property to kids, right?
• 17:10
  SPEAKER_00: So you could, so let's say you had a hundred million dollar uh$100 million worth of gain in your qualified small business stock, but you only have a$10 million exclusion, right?
• 17:22
  SPEAKER_00: Well, each individual can qualify for the exclusion on their own, right?
• 17:27
  SPEAKER_00: If they have a social security number or a tax ID, right, they can potentially qualify.
• 17:32
  SPEAKER_00: So you can give some to your son, some to your daughter, uh, maybe, and then give some into trust.
• 17:38
  SPEAKER_00: As long as it's a non-grantor trust, that's a different taxpayer.
• 17:42
  SPEAKER_00: So you basically just in that illustration between your son, your daughter, and maybe a irrevocable non-grantor trust for the benefit of both of them, right?
• 17:53
  SPEAKER_00: It's a different tax ID.
• 17:54
  SPEAKER_00: So you basically stacked three additional$10 million exclusions from one issuer of stock.
• 18:02
  SPEAKER_00: Does that make sense?
• 18:03
  SPEAKER_00: So that's stacking it up.
• 18:05
  SPEAKER_00: You're basically spreading out those exclusions by gifting stock.
• 18:09
  SPEAKER_01: Absolutely.
• 18:10
  SPEAKER_01: So uh and I'll I'll give you a bonus question then.
• 18:14
  SPEAKER_01: Uh, how about a married couple?
• 18:15
  SPEAKER_01: Are is that is that a single taxpayer, or do you get you could you potentially do the stacking on both of those people?
• 18:22
  SPEAKER_00: Yeah, you know, that's that's a great question.
• 18:24
  SPEAKER_00: I know that um there's there's been uh some some guidance issued by the Internal Revenue Service where they they frown on gifting stock to a spouse that files a separate return.
• 18:38
  SPEAKER_00: But but but what's really unclear, and and I have I know some clients that have done this, is they've given stock, qualified small business stock before a transaction to their wife to equalize the estate, right?
• 18:52
  SPEAKER_00: So, and they take the position that she's a holder of qualified small business stock, he's a holder of qualified small business stock, and then both of their children are holders of qualified small business stock by subsequent gifts, right?
• 19:07
  SPEAKER_00: From each of them, right?
• 19:09
  SPEAKER_00: So, so you can do that.
• 19:10
  SPEAKER_00: It's it's a little bit of a gray area on how the service is is gonna look at it.
• 19:17
  SPEAKER_00: But certainly if you file a separate return, they've they've gone after, for whatever reason, it doesn't really make sense to me.
• 19:24
  SPEAKER_00: They've they've kind of frowned on that, but but certainly um it's well within uh a reasonable position to take that on the front end to equalize the estate, one spouse can because there's an unlimited transfer of between married couples, right?
• 19:43
  SPEAKER_00: Because the internal revenue code looks at a married couple as a single economic unit, right?
• 19:48
  SPEAKER_00: So you can have an unlimited amount of property transfer back and forth between husband and wife.
• 19:54
  SPEAKER_01: Right.
• 19:56
  SPEAKER_01: Well, I think the biggest lightning uh component of that lightning round was just the uh the mind-blowing information that that we had there.
• 20:03
  SPEAKER_01: Uh, you know, we took a took a minute to go over all the good stuff, but you know, let's let's wrap it up, let's conclude.
• 20:09
  SPEAKER_01: Gary, what is the single most important thing that every business owner should know about QSBS before they think about selling?
• 20:18
  SPEAKER_00: Yeah, just just take a step back and look at your business, right?
• 20:23
  SPEAKER_00: And if if in the spirit of beginning with the end in mind, if your exit is going to be the sale of equity versus the sale of assets, right?
• 20:33
  SPEAKER_00: Because some businesses are more conducive to selling assets, but a lot of businesses are having exits where they're selling the equity of their business.
• 20:42
  SPEAKER_00: So you take a step back and say, what's my exit?
• 20:45
  SPEAKER_00: Begin with the end in mind.
• 20:46
  SPEAKER_00: If I'm going to be selling equity, right, do I have a qualified trader business that meets those requirements, right?
• 20:53
  SPEAKER_00: And if you do, it might make sense if you're an LLC or an S Corp to reorganize to a C Corp.
• 21:01
  SPEAKER_00: And then, you know, obviously you would have to hold it for five years and then make the sale.
• 21:07
  SPEAKER_00: But most people are, you know, have a five to 10 year exit ramp anyway.
• 21:12
  SPEAKER_00: So early on, just begin with the end in mind, understanding what your exit looks like, right?
• 21:18
  SPEAKER_00: And if you qualify, you you uh you you want to make the conversion to to the C Corp.
• 21:25
  SPEAKER_00: And if you're just starting out, you want to start out as an LLC, monitor your valuation by having you take a look at the books every year, give them an updated appraisal when they get close to that 50 million mark, all things being equal, meaning they've met all the other requirements, then they reorganize from that LLC to the C Corp.
• 21:48
  SPEAKER_00: And then that's you know, they they they basically take their$10 million exclusion and turn it into a$200 million exclusion, like in our example.
• 22:00
  SPEAKER_00: But if if the value of your LLC is$45 million upon the day that you convert to a C Corp, you can exclude up to$450 million on your exit.
• 22:13
  SPEAKER_00: Right.
• 22:14
  SPEAKER_00: So that's probably a long-winded answer, but that covers kind of the the main points, the main considerations.
• 22:20
  SPEAKER_01: Absolutely.
• 22:21
  SPEAKER_01: Think about it first.
• 22:22
  SPEAKER_01: And if you're a small business owner and you're thinking about trying to take advantage of this, think about it early.
• 22:28
  SPEAKER_01: And you know, Mr.
• 22:30
  SPEAKER_01: Whitfield, you're the uh master exit planner and QSBS uh whisperer.
• 22:37
  SPEAKER_01: So how can folks out there reach you for your guidance?
• 22:41
  SPEAKER_00: Yeah, I mean, then um you can refer your clients over, but we we have um you know we have a website, um, Paraclet Strategic Consulting dot com or Paraclet Wealthpartners.com.
• 22:54
  SPEAKER_00: Again, two different two different practices, one's wealth management, one's strategic consulting, but you can you can reach us through either site.
• 23:03
  SPEAKER_01: Awesome.
• 23:04
  SPEAKER_01: Okay.
• 23:04
  SPEAKER_01: Well, Gary, hey, thanks very much for that video with me.
• 23:08
  SPEAKER_01: It was it was a lot of fun talking.
• 23:09
  SPEAKER_01: Thanks.
• 23:10
  SPEAKER_01: All right.