An obscure tax exemption called 'QSBS' can save you millions when you sell your startup. Here are the 4 basic criteria to follow to make sure you get it.

• A little-known tax perk called Qualified Small Business Stock, or QSBS, can supersize your startup's exit payout by wiping out long-term capital gains taxes on at least $10 million in profits - or on a whopping ten times the amount of your original investment - whichever is bigger.
• With QSBS, you can wave some or all federal taxes on the sale. Some states, like New York, also abide by QSBS (Sorry, California does not).
• There are a lot of pitfalls when setting yourself and your company up for QSBS. Use this 4-part checklist to make sure you pocket every penny possible. Start by planning for QSBS early in your startup's life cycle.

Qualified Small Business Stock, or QSBS, is something every founder and early-stage investor should know about.

The little-known tax exemption lets these early shareholders avoid paying long-term capital gains taxes to the federal government when they sell their shares. Some states allow you to wave long-term capital gains taxes as well with QSBS.

The tax break is potentially huge and applies to at least $10 million in the shareholder's profits or up to 10 times their original investment, whichever is bigger.

That means, if you sell your startup for $10 million and you own 100% of the shares, you can potentially pocket all $10 million, minus what you initially paid for the shares. Without QSBS, you'd be giving giving roughly one-third of your payout away in taxes (20% in federal, 3.8% for the Obamacare levy, plus up to 13.4% in state depending on where your business is owned and operated).

Not every small business qualifies for QSBS. The company needs to be set up in a very specific way to reap the federal tax benefits. There are four main criteria you and your startup need to meet:

1. You need to receive shares in the company when it is still small - when that company has gross assets of $50 million or less. If you get shares of a company like Airbnb right now, for example, it's too late to qualify for QSBS. Your startup also has to use at least 80% of its assets to conduct its business. So no hoarding cash that doesn't actually contribute to the company's operations.2).
2. The company has to be set up as a C corporation. If your company is set up as a partnership, limited liability company or another so-called "passthrough" that, unlike a C corporation, doesn't pay taxes at the entity level, no dice.
3. Your startup has to actually create or manufacture stuff, like new forms of technology or widgets. And it has to be in a field that qualifies for the benefit. Service firms in law, finance, architecture, accounting, and health care (i.e. doctors' offices) don't qualify. Neither do real-estate investment trusts, sales companies, restaurants, hotels or oil and gas extractors. Cooley's Lee said that while the benefit is mainly for technology companies, he has a lot of brick-and mortar manufacturing companies in the Midwest that qualify for QSBS too.
4. You generally have to hold onto your stock for at least five years before selling it. There are a couple ways around this qualifier, though (more on that below). But if you're granted stock options, and not actual shares, your payout horizon is much longer -- the 5-year holding period starts the day you exercise them, not the day they're granted. Which means QSBS typically has the most bang for the buck when you're a founder, angel investor or board member, since those are the people that typically get actual stock in a seed company.

There are ways around the 5-year rule, along with a means to make your family members rich from your qualifying QSBS.

Here's everything you need to know about setting up QSBS, how it works, and common pitfalls to avoid.

NOW WATCH: Why red and green are the colors of Christmas