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How do founders get more out of the QSBS exclusion?

TaxEquityQSBS

A founder who bought stock at par has almost no basis in it, so their QSBS exclusion is capped at $15 million, and in a large exit everything above that is taxed. The two ways around the cap both work by changing who holds the stock or what it cost them. Converting an LLC into a C corporation gives the founders a basis equal to the value of the business on the day of conversion, and ten times that basis can be far more than $15 million. Gifting QSBS to family members or trusts gives each recipient their own exclusion. Both are legitimate, both are complicated, and for a first-time founder forming a company this year, the plain Delaware C corporation is almost always still the right answer.

The LLC conversion

Two founders form a C corporation on day one, buy their shares for a nominal price, and sell six years later for $400 million. Each excludes $15 million; the rest is taxed. The same two founders form an LLC instead, convert it to a corporation when the business is worth $40 million, and sell five years after that for the same $400 million. Their basis for QSBS purposes is now $20 million each, their cap is ten times that, and the $360 million of gain above the conversion value is excluded; only the $40 million that had accrued before the conversion is taxed. The larger the exit, the larger the difference.

What the conversion costs

The holding period starts at the conversion, not at formation, so the founders wait longer for the exclusion. The conversion has to happen while gross assets are still under $75 million, and it needs a valuation that will hold up alongside the company's 409A and financing valuations. A leveraged LLC can produce tax on conversion. An LLC is more expensive to run and harder to raise money into, and an investor who arrives before the conversion will require it as a condition of the round. And in a modest exit the strategy loses: appreciation before conversion is taxed, so a founder who converts at $30 million and sells at $39 million would have done better with a corporation from the start. The strategy does not work at all from an S corporation, whose stock is never QSBS.

Stacking by gift

The exclusion is per taxpayer per company, so three co-founders have three exclusions where one founder has one. A founder can multiply their own by giving stock to family members or to trusts that are taxed separately, since a gift, unlike a sale, does not break the original-issue requirement. This is done early, while the stock is worth little and the gift tax is small. It means genuinely giving the stock away, transfers between spouses do not multiply the exclusion the way gifts to others can, and the IRS has shown interest in arrangements that look like a founder spreading one exclusion across relatives who never see the money. It is a tax advisor's project, not a form.

For nearly every founder the version of this that matters is the simple one: form a C corporation, buy your stock at formation, file the 83(b), hold for five years. The strategies above are for a founder who already knows the exit will be large and has advisors who do this for a living.

Written by the lawyers who built Arabella. This is legal information, not legal advice for your situation, and reading it does not make us your lawyers. For a real dispute or a high-stakes decision, talk to a licensed attorney. More questions.