Confused about QSBS eligibility - do I need C-corp from day one?

I'm incorporating my SaaS startup and heard about Qualified Small Business Stock (QSBS) which lets you exclude up to $10 million in capital gains from taxes if you hold the stock for 5 years.

My lawyer is saying I need to form as a C-corp to qualify for QSBS. But I was planning to do an LLC with S-corp election because I heard that's better for taxes early on.

Do I really need to be a C-corp from the beginning? Can I convert later and still get QSBS treatment? Trying to figure out if it's worth it.

Your lawyer is correct. QSBS only applies to stock in C-corporations. IRC Section 1202 is very specific about this.

Here's the issue with converting later: the 5-year holding period starts when the stock is ORIGINALLY issued. If you start as an LLC and convert to C-corp later, your stock gets reissued at the conversion date. You lose all the time before that.

Example: You form an LLC in 2025, convert to C-corp in 2027, sell in 2032. You only have 5 years of holding from 2027-2032, so you qualify. BUT if you exit in 2031, you only have 4 years and don't qualify for QSBS at all.

Ok that makes sense. But what about the double taxation issue with C-corps? I've heard you get taxed at the corporate level AND when you take distributions.

Is QSBS worth dealing with that?

Former startup founder here - raised $15M, exited for $85M, saved over $8M in taxes because of QSBS. 100% worth being a C-corp.

The "double taxation" thing is overblown for venture-backed startups. You're not taking distributions early on - you're reinvesting everything into growth. The corporate tax only matters if you're profitable AND taking money out, which most startups don't do.

When you exit, QSBS lets you exclude up to $10M in gains (or 10x your basis, whichever is greater). Federal capital gains tax is 20%, so that's potentially $2M saved per founder. Way more valuable than saving a few points on S-corp self-employment taxes.

Let me add the specific QSBS requirements since there's more to it than just being a C-corp:

• Must be a C-corp: Can't be an S-corp, LLC, partnership, or sole proprietorship
• Gross assets under $50M: At the time the stock is issued AND immediately after. This is why you need to start as C-corp - if you convert after raising money, you might already exceed $50M
• Active business requirement: At least 80% of assets must be used in the active conduct of a qualified trade or business
• Original issuance: You must acquire the stock directly from the company (not from another shareholder)
• 5-year holding period: You must hold the stock for at least 5 years before selling

There are also some excluded industries: professional services (law, accounting, consulting), banking, insurance, farming, mining, and hospitality.

Wait, the $50M limit is at the time stock is issued? So if I issue my founder shares now while assets are basically zero, I'm good even if the company later becomes worth $500M?

Exactly right. The $50M test is applied at the time YOUR specific shares are issued. That's why founders who get stock on day one when the company is worth nothing are in the best position.

Later investors might not qualify if the company has grown beyond $50M in assets by the time they invest. Employees getting stock grants 3 years in also might not qualify if assets exceed $50M at grant date.

This is another reason to incorporate as C-corp immediately - your founder shares get issued when assets are definitely under $50M.

I want to clarify the "10x your basis" rule because I see a lot of confusion about this.

The QSBS exclusion is the GREATER of:

1. $10 million, OR
2. 10 times your adjusted basis in the stock

So if you invested $100 to buy your founder shares (typical for founders), your basis is $100. 10x that is $1,000 - way less than $10M. You'd use the $10M limit.

But if you're an investor who put in $5M, your basis is $5M, and 10x is $50M. In that case you could exclude up to $50M in gains, not just $10M.

This makes QSBS incredibly valuable for early investors in successful companies.

One thing to watch out for: the "redemption" rules. If the company buys back more than a de minimis amount of stock from you or related parties during a specific period around your stock issuance, you can lose QSBS treatment.

Specifically, if the company redeems more than $10,000 of stock from you in the 2-year period (1 year before and 1 year after) you acquire your QSBS, your shares don't qualify.

This has caught people off guard when they do founder stock buybacks or when companies repurchase shares from departing employees.

This is all super helpful. Sounds like for any startup that might want to raise VC funding or have a significant exit, C-corp is the way to go from day one.

What about state taxes though? Does QSBS exclusion apply at the state level or just federal?

QSBS is a federal tax benefit under IRC Section 1202. State treatment varies:

• States that fully conform: Alabama, Arizona, Arkansas, DC, Kansas, Minnesota, Mississippi, Montana, New Mexico, North Dakota, South Carolina, Wisconsin
• States with no income tax: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, Wyoming - QSBS doesn't matter since no state cap gains tax anyway
• States that DON'T conform: California (ouch - 13.3% top rate still applies), Massachusetts, Pennsylvania, New Jersey, Hawaii, Alabama

California is the painful one. You save on federal taxes but still pay the full 13.3% state capital gains rate. Some founders actually move out of California before their exit specifically for this reason.

Really appreciate everyone's input here. Going to incorporate as a Delaware C-corp. The potential tax savings on exit way outweigh any short-term benefits of S-corp treatment.

One last question - is there any downside to doing an 83(b) election with QSBS? My lawyer mentioned I should file that too.

83(b) election is critical for founders with restricted stock that vests. Without it, you're taxed as the stock vests (potentially at much higher valuations). With 83(b), you pay tax upfront based on current value (usually near zero for founders).

More importantly for QSBS: the 5-year holding period starts when you FILE the 83(b), not when the stock vests. So if you have a 4-year vesting schedule and don't file 83(b), you won't hit 5 years of holding on your last vested shares until 9 years after founding. File 83(b) and the clock starts immediately for all shares.

You have 30 days from the grant date to file 83(b) with the IRS. Don't miss this deadline - it's not extendable and missing it can cost millions in taxes.