How to Build a Multimillion-Dollar Portfolio – Entirely Tax-Free!

How to Build a Multimillion-Dollar Portfolio – Entirely Tax-Free!
By Adam Sharp
Date June 9, 2017

The first time I read about qualified small business stock (QSBS), I had trouble believing it.

A way to pay zero federal taxes on startup investment profits? It seemed way too good to be true.

As I continued researching it, though, I couldn’t help but grin. I had found a genuine, little-known, legitimate tax loophole. One that makes something I already love – investing in startups – even more attractive.

QSBS is covered in Section 1202 of the Internal Revenue Code. As of January 2015, it allows certain startup investment profits to be 100% free of federal taxes.

The vast majority of companies we recommend in First Stage Investor can be categorized as QSBS.

QSBS can eliminate 100% of federal capital gains taxes on startup investments as long as…

  • The company was worth less than $50 million when shares were purchased
  • You hold the investment for at least five years
  • The company is a domestic (U.S.) C corporation (almost all startups are)
  • You’re the original purchaser (not secondhand shares)
  • Your gain is less than $10 million
  • You bought the stock after September 27, 2010.

If you’re new to startup investing, the five-year holding period may give you pause. However, when you’re investing in early-stage companies, this is to be expected. You should think about these investments as truly long term – not something you trade in and out of. (I cover this concept more in depth here.)

Any gains taken before the five-year holding period can also be exempt from federal taxation. In that case, you need to have owned the stock for at least six months, and you need to roll the profits into a new QSBS within 60 days.

Let’s take a quick hypothetical look at what this could mean for a regular investor…

In January 2017, John Smith decides to take a stake in Acme Inc., a QSBS that meets all the requirements listed above.

He invests $5,000. Five years go by, and Acme has done very well. John Smith cashes out and collects, say, $100,000.

That’s a $95,000 capital gain. And for those in the top 39.6% bracket for ordinary income, the capital gains tax rate is 20 percent.

So if John Smith had invested in regular stocks, he would have had to pay $19,000 in taxes. His net profit would be $76,000.

But thanks to this loophole, he walks away with every last cent of his $95,000 profit!

Now, we are not tax professionals. This is just an example, and your situation will likely vary.

But the opportunity here is amazing. In theory, you could make up to $10 million – tax-free!

We will attempt to get necessary documentation from founders that prove their companies’ shares qualify as QSBS. This should be required only if you’re audited and need to provide backup for the exclusion.

Why Haven’t You Heard of This?

QSBS presents a unique opportunity. It can have tax benefits similar to those of a Roth IRA.

So why have most people never heard of this?

To start with, investments in companies worth less than $50 million are rare in the U.S. There are very few publicly traded companies with valuations (market capitalizations) that small.

Before equity crowdfunding, the only people who invested in sub-$50 million companies were venture capitalists and angel investors.

So this is probably a loophole that institutional investors lobbied for. But now… we can all benefit from it, thanks to equity crowdfunding.

Further Reading
For more information on qualified small business stock, see these helpful articles…

Disclaimer: Please do your own research into qualified small business stock, and consult a tax professional if you’re not sure how to proceed. We cannot answer questions about your individual tax situation. Please consult the resources provided above.