Tax Treatment for Startup Investors
QSBS exclusion, capital gains, and treaty benefits for foreign investors
Key Tax Benefits
100%
QSBS Exclusion
$10M
Max Exclusion
5 yr
Holding Period
0%
Treaty Rate (Many)
$1M gain difference: QSBS exclusion (0%) vs ordinary income (37%+) = $370K+ tax savings
QSBS: The 100% Exclusion (Section 1202)
Section 1202 allows investors to exclude up to 100% of capital gains on Qualified Small Business Stock from federal income tax. This is one of the most powerful tax benefits available.
Exclusion Limits
- Greater of $10M or 10x basis
- Per-issuer limit (each company)
- 100% exclusion for stock after 9/27/2010
- No AMT adjustment
Core Requirements
- Stock from C Corporation
- Acquired at original issuance
- Held 5+ years
- Company under $50M assets at issuance
QSBS Requirements
Company Requirements
Entity Structure
- Must be C Corporation
- Domestic US corporation
- Cannot be LLC or S Corp
- C Corp status at all times during hold
Asset Test
- Under $50M gross assets at issuance
- Measured before and after investment
- Includes all company assets
- Test applies at stock issuance date
Active Business
- 80%+ assets in active operations
- Cannot be passive investments
- Cannot be holding company
- Must operate genuine business
Excluded Industries
- Personal services (law, accounting)
- Banking and financial services
- Hospitality (hotels, restaurants)
- Farming and extraction
Investor Requirements
Acquisition Method
- Acquired at original issuance
- Cannot be secondary purchase
- Exchange for money or property
- Stock-based compensation may qualify
Holding Period
- Must hold 5+ years from acquisition
- No exceptions for early exit
- M&A before 5 years loses benefit
- Section 1045 rollover available
Convertible notes and SAFEs: QSBS period starts at conversion, not investment date.
5-Year Holding Period Timeline
| Investment Type | Holding Period Starts | Notes |
|---|---|---|
| Direct stock purchase | Purchase date | Immediate start |
| Convertible note | Conversion date | Often 12-24 months after investment |
| SAFE | Conversion date | Can remain unconverted for years |
| Stock options | Exercise date | Not grant date |
M&A before 5 years: Cash deals end QSBS benefit. Stock-for-stock may preserve via Section 1045.
Foreign Investor Considerations
When QSBS Matters for Foreigners
QSBS is a US tax benefit. How it applies depends on whether you're subject to US tax on gains.
| Your Situation | US Tax on Gains | QSBS Benefit |
|---|---|---|
| Non-resident, no US nexus, treaty country | 0% (treaty) | Not needed |
| Non-resident, no treaty | 0% (no nexus) | Not needed |
| US business activity (ECI) | Up to 37% | Full benefit |
| USRPHC (FIRPTA) | 15% withholding | May apply |
| US resident for tax purposes | Up to 23.8% | Full benefit |
If you plan to move to the US before exit, QSBS planning becomes critical.
Tax Treaty Benefits by Country
| Country | Capital Gains Treatment | Key Conditions |
|---|---|---|
| United Kingdom | Exempt from US tax | No US permanent establishment |
| Germany | Exempt from US tax | No US permanent establishment |
| Canada | Exempt from US tax | Not former US citizen/resident |
| France | Exempt from US tax | No US permanent establishment |
| Japan | Exempt from US tax | No US permanent establishment |
| China | May be taxable | Limited capital gains protection |
File Form W-8BEN to claim treaty benefits. Without it, payer may withhold US tax.
Capital Gains Without QSBS
If your investment doesn't qualify for QSBS (LLC, short holding, excluded industry):
| Holding Period | Treatment | Rate (2025) |
|---|---|---|
| Less than 1 year | Short-term capital gain | Up to 37% |
| More than 1 year | Long-term capital gain | 0%, 15%, or 20% |
| LTCG + NIIT | With Net Investment Income Tax | Up to 23.8% |
| 5+ years with QSBS | Section 1202 exclusion | 0% |
California does not recognize QSBS. CA residents owe up to 13.3% on gains even if federally excluded.
Planning Recommendations
Before You Invest
Verify Structure
- Confirm C Corporation status
- Request $50M asset test confirmation
- Check for excluded industries
- Consider direct stock over SAFEs
Understand Your Status
- Determine US tax nexus at exit
- Review applicable tax treaties
- File W-8BEN for treaty benefits
- Plan for status changes
While Holding
Track Everything
- Know your 5-year eligibility date
- Monitor company structure changes
- Keep purchase documentation
- Save company QSBS representations
At Exit
- Time sales after 5-year mark
- Consider Section 1045 rollover
- Plan state residence for large exits
- Coordinate with home country tax