You Built a Unicorn. The IRS Took $2.3 Million.
I met a founder recently who sold his company for $10 Million. He was popping champagne. He thought he qualified for QSBS (Qualified Small Business Stock). Under Section 1202, that means 0% Federal Tax. He expected to keep all $10M.
The IRS audited him. They found a paperwork error from 4 years ago. The Verdict: QSBS Denied. The Bill: He owed 23.8% (Capital Gains + NIIT) on the sale. He wrote a check for $2,380,000 to the government because he didn't read the fine print.
Section 1202 is the greatest gift in the US Tax Code, but it is a minefield. Here are the three ways you are accidentally killing your exemption right now.
1. The "LLC" Trap (The Clock Hasn't Started)
You started as an LLC to "save money on filings." You ran the business for 3 years. Then you converted to a C-Corp to raise VC money. You sold the company 3 years later.
You lose. To qualify for QSBS, you must hold the C-Corp stock for 5 Years. The 3 years you spent as an LLC do not count.
- Your Holding Period: 3 Years.
- Required: 5 Years.
- Tax: Full Capital Gains.
The Fix: If you want a Venture Scale exit, incorporate as a Delaware C-Corp on Day 1. Do not mess around with LLCs.
2. The "Redemption" Trap (Don't Buy It Back)
This is the most obscure rule that kills startups. Section 1202(c)(3) says: "If the company buys back any stock from a founder within 2 years of issuing new stock, the new stock might be disqualified."
Scenario:
- You found the company.
- Your co-founder quits.
- The company "redeems" (buys back) his shares for $10,000 to get him off the cap table.
- Result: You might have just tainted the QSBS status for everyone else's shares issued around that time.
The IRS views buybacks as "Churning." If you touch the cap table without a lawyer, you are playing with fire.
3. The "California" Surprise
You live in San Francisco. You sell your startup. Federal Tax: $0 (QSBS). California Tax: 13.3% (or 14.4% in 2025).
Surprise: California does not recognize QSBS. New York generally doesn't either. Even if you win the Federal game, the Franchise Tax Board will still take their cut. The Fix: This is why founders move to Texas or Florida before they sell. You cannot escape California tax if you are a resident when the wire hits.
The Real Numbers: The $10 Million Difference
I calculated the take-home pay on a $10M exit with and without QSBS.
| Tax Type | Standard Exit (No QSBS) | QSBS Exit (Done Right) |
|---|---|---|
| Federal Capital Gains (20%) | -$2,000,000 | $0 |
| NIIT Surtax (3.8%) | -$380,000 | $0 |
| State Tax (Avg 5%) | -$500,000 | -$500,000 |
| Total Tax Bill | $2,880,000 | $500,000 |
| Net to Founder | $7,120,000 | $9,500,000 |
The Verdict: Hiring a $1,000/hour lawyer to verify your QSBS eligibility is the best ROI you will ever get.