For many MSP owners, selling their business is a once-in-a-lifetime opportunity. While deal structure, valuation, and cultural fit are top concerns, tax implications can have an equally significant impact on how much money ends up in your pocket. One tax incentive often overlooked by MSP owners is Qualified Small Business Stock (QSBS), which can offer significant tax savings if properly leveraged.
What is QSBS?
Qualified Small Business Stock (QSBS) is a tax benefit under Section 1202 of the Internal Revenue Code that allows shareholders of eligible small businesses to exclude up to 100% of capital gains from federal taxes when they sell their shares. This can translate into massive tax savings, making it a critical planning tool for MSP owners considering a sale.
Does Your MSP Qualify for QSBS?
To take advantage of QSBS, your MSP must meet specific requirements:
- Entity Structure: The business must be a C Corporation when the stock is issued.
- Gross Assets Test: The company must have less than $50 million in gross assets at the time the stock is issued and immediately afterward.
- Active Business Requirement: At least 80% of the company’s assets must be used in an active trade or business (technology services, like MSPs, generally qualify).
- Original Issuance: The stock must be acquired directly from the company (not purchased from another shareholder).
- Holding Period: The stock must be held for at least five years to qualify for the full tax exclusion.
How Much Can You Save with QSBS?
Under QSBS, eligible shareholders can exclude 100% of capital gains on the sale of stock, up to a limit of $10 million or 10 times the basis of the stock, whichever is greater. This means if you sell your MSP for $10 million and meet all QSBS criteria, you could potentially avoid paying federal capital gains tax entirely—a savings of millions compared to the typical 20% long-term capital gains tax rate.
Potential QSBS Pitfalls for MSP Owners
While QSBS offers substantial tax benefits, MSP owners should be aware of potential pitfalls:
- S-Corp vs. C-Corp: Many MSPs are structured as S-Corps or LLCs for tax efficiency. Unfortunately, QSBS only applies to C Corporations, meaning a conversion may be required—but this must happen before issuing QSBS-eligible stock.
- Five-Year Holding Period: The tax benefits require a five-year holding period. If you’re planning to sell sooner, QSBS may not be as beneficial.
- State Tax Considerations: Not all states conform to federal QSBS rules. States like California do not offer QSBS benefits, meaning you may still owe state capital gains tax.
- Buyout Structure: If your MSP is acquired through an asset sale instead of a stock sale, QSBS won’t apply. Many MSP deals are structured as asset sales for tax and liability reasons, so structuring the sale correctly is critical.
Strategies to Leverage QSBS Before Selling Your MSP
If you think QSBS could apply to your MSP sale, consider these strategies:
- Convert to a C-Corp Early: If your business is currently an LLC or S-Corp, discuss converting to a C-Corp well in advance of a sale to ensure eligibility.
- Ensure Proper Stock Issuance: QSBS applies to original stockholders. If issuing stock to new investors, ensure compliance with QSBS rules.
- Plan for the Five-Year Rule: If a sale is on the horizon, consider whether you can hold for five years to maximize tax benefits.
- Work with Tax & Legal Advisors: QSBS rules are complex, and a single misstep could disqualify you from millions in tax savings. An experienced tax attorney or CPA with M&A experience can help ensure compliance.
Is QSBS Right for Your MSP Exit Strategy?
While QSBS presents an incredible opportunity for tax savings, not all MSP sales will qualify due to entity structure, sale format, or timing. If you’re planning an exit, it’s worth evaluating whether restructuring your business in advance could help you benefit from QSBS. The earlier you plan, the greater the potential savings.
This article is intended to create awareness about QSBS benefits, but every MSP owner’s situation is unique. It is always best to consult with an accounting professional to understand how QSBS may apply to your specific circumstances.
If you’re considering selling your MSP and want to explore the best financial strategies, we’d love to connect. Dune Creek partners with best-in-class MSPs, providing tailored solutions to maximize value and ensure long-term success. Reach out to discuss how we can help you navigate the M&A process while optimizing your tax position.
