Context, Criteria, & Claiming the Qualified Small Business Stock (QSBS)
By Ian O'Bryan and Tim Hsia
At Context Ventures we’ve taken an extensive look at the benefits of meeting Qualified Small Business Stock (QSBS) requirements defined under Section 1202 of the IRS’s code of 1984. Tax law is unsettled in certain circumstances, but we hope these notes will help with your investment decisions as you think about the tax ramifications of different term sheets. Please also reference our disclaimer at the bottom of this essay.
QSBS was designed to promote investment in higher-risk start-ups and small businesses by rewarding investors with significant capital gains tax reductions. Over the rule’s 30-year history there have been three time periods with differing tax reductions, we’ll focus on the most recent taking effect on 27 September 2010.
If a company and investor meet QSBS requirements outlined in Section 1202, tax reductions will be reduced 100% (with a cap) with no Alternative Minimum Tax (AMT) added back following a 5-year holding period.
Here’s an overview of QSBS requirements for company, investor, and state adherence:
Company
All QSBS eligible companies must be a US C-corporation with less than an aggregate of $50M in assets at the time of stock issuance. Several industries do not qualify for QSBS including:
A business involving services performed in the field of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services.
A business whose principal asset is the reputation or skill of one or more employees.
A banking, insurance, financing, leasing, investing, or similar business.
A farming business (including the raising or harvesting of trees).
A business involving the production of products for which percentage depletion can be claimed.
A business of operating a hotel, motel, restaurant, or similar business.
Founder or Investor
To be eligible for QSBS exclusions, the holder of the stock issuance must be an individual, trust, or pass-through entity; it cannot be a company. The said investor must hold the QSBS stock for five years before being eligible for tax exclusions. More specifics are listed below:
If sold before 5 years, and the investor reallocates gains to another QSBS stock, the investor is able to avoid capital gains tax until the 5-year holding period expires in another company.
The investor must have acquired stock from the original issue.
Some loopholes are available if you acquired stock, through a gift or inheritance, from another person who met original QSBS requirements.
Marriages
Each “taxpayer” is entitled to $10M in tax exclusions. However, since “taxpayer” is not defined, it could allow both members of a marriage to be entitled to $10M in tax exclusions each.
Partnerships, though normally conducive to tax advantages, do not apply to QSBS.
For a founder to be eligible for QSBS they must do the following:
Found a company that is QSBS eligible
Submit an 83(b) election to the IRS within 30 days of receiving/creating shares
This effectively is a short document stating you wish your shares to be taxed at fair market value when granted versus when vested.
Hold for 5 year period
State Adherence
Most states follow federal IRS guidelines, however, a few don’t comply. These include:
Alabama
California
Mississippi
New Jersey
Pennsylvania
Puerto Rico
The following states partially follow QSBS guidelines
Hawaii
Massachusetts
Tax benefits
If QSBS is purchased after 27 September 2010 and held for a minimum of 5 years, the sale is eligible for 100% federal capital gains exemption with no Alternative Minimum Tax (AMT) add back. The federal capital gains exclusion is capped at the greater of $10 million or 10x the adjusted basis of the shares.
Transaction Types
QSBS consists of cash/property exchanged for stock. An IRS note in a separate suit clarified that stock has a broader definition than a certificate, that “stock ownership is a matter of economic substance.” There are several arguments in defense of SAFE’s being a stock transfer, the most recent (2018) edition of the YC SAFE contains an updated section 5 (g) with strengthened language to cement the intent to transfer stock for cash. The point of concern is if the IRS will view a SAFE as a prepaid forward contract, or cash paid upfront with the promise of a variable amount of stock at a later period. Unfortunately, the 5-year holding period only commences upon the exchange of stock. Our analysis of the benefits of the three primary deal terms is listed below:
A Priced Round
A priced round is a defined amount of stock exchanged for cash or property (not stock). A 5-year holding period commences immediately if both company and investor meet requirements. Extremely clear cut for QSBS purposes.
Convertible note
Assuming the company and investor meet QSBS eligibility, the five-year holding period commences once the note converts to equity. Convertible notes are not tax efficient from a time horizon perspective.
SAFE
At the 27th Private Equity & Venture Capital Conference hosted by PWC and Cooley on 7/18/23, PWC partners confirmed that the new (2018), undoctored version of the Y-Combinator SAFE has enough equity language to build a position that it can qualify for QSBS. The first iteration of the Y-Combinator SAFE, unfortunately, doesn’t contain enough equity-like language to cross the threshold to be considered eligible for QSBS.
The new SAFE edition was created in late 2018, and for that reason we expect several SAFE investors to liquidate their positions and claim QSBS tax exclusions late this year (2023). We expect a clearer picture of how the IRS views the new SAFE amendments once these investment’s holding periods expire. Best case scenario, the SAFE’s holding period commences immediately upon agreement signing, worst case it commences once a defined amount of stock is exchanged.
Takeaway
QSBS is a fantastic tax-efficient method to invest in small businesses and startups. All three deal types (convertible notes (CN), SAFEs, and Priced Rounds) eventually can be QSBS eligible, however, priced rounds and (potentially) 2018 edition YC SAFEs are the only transaction types in which the 5-year QSBS holding period commences immediately. From a VC/Founder perspective, priced rounds are the clearest path to QSBS savings, with SAFEs a strong possibility, and convertible notes requiring conversion to equity to qualify. The tax benefits of 100% federal capital gains exemption with no Alternative Minimum Tax (AMT) add back cannot be understated and are a significant value proposition for the sophisticated investor. If the startup you are investing in or founding is QSBS eligible, we highly recommend ensuring you meet all requirements to take advantage of this exceptional tax-efficient opportunity.
References
https://www.irs.gov/pub/irs-wd/201636003.pdf
https://www.irs.gov/instructions/i1040sd#en_US_2021_publink1000285558
https://acuity.co/founder-stock/#
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