Hank Reiling, one of my favorite professors at HBS, taught his students in his excellent class “Tax Factors in Business Decisions,” that is it best to approach tax law not as simply rules-driven, but to understand the purpose behind the rules. In this case, the goal is clear and noble – to stimulate new investment in startups, and particularly technology startups.
The Qualified Small Business Stock (QSBS) tax rules (IRC Section 1202 and related Section 1045) have significant economic benefits for founders, employees, and venture capital investors. We are encouraging all of our portfolio company founders and CEOs to pay special attention to these rules to make sure they understand them so that they can benefit when eligible and avoid disqualifying foot faults.
If you own QSBS stock, you may be eligible for a 100% exclusion from federal income tax on gains equal to the greater of: (1) $10mm or (2) 10x tax basis. As with all tax laws, it is inevitable that these rules will change in the future. However, the benefit is at this time is significant.
I will provide illustrative examples below (from the perspective of founders, employees, and venture capital investors), give a high-level overview of the qualification requirements, and throughout address specific questions some of our portfolio company founders have raised.
In the first example above, Founder 1 owns 50% of the business and achieves an exit value of $25mm. Because the cost basis is low, the maximum QSBS exemption is $10mm. This scenario results in a tax savings of $2.4mm or 80% of what they would have owned were the stock not QSBS.
In the second example, Founder 2 owns 50% of the business and achieves a successful exit value of $300mm. In this case, the founder’s tax basis is $15mm. The basis could be created, for example, when a founder initially sets up the business as an LLC and then subsequently converts the business to a C-Corp and exchanges his LLC interests valued at $15mm for C-Corp shares. In this case, the founder can claim a Section 1202 exemption of 10x his basis of $150mm on his taxable gain amount. The tax savings here are an impressive $32mm or 100% tax savings.
Founders often wonder how best to set up their company upon founding. As described below in the Eligibility section, founder stock issued by a C-corp can qualify for QSBS. Additionally, LLC interests exchanged for C-corp stock may also be eligible. S-corps are more challenging. Generally, upon conversion to a C-corp, the S-election is dropped, but the shares are tainted because they were not originally issued by a C-corp. There are structures that could lead to a new C corp issuance, but these may come with a tax cost.
There are additional workarounds if your founder shares are S-Corp shares. The S-Corp may transfer all of its assets to a newly established C-Corp (NEWCO) in exchange for shares in the NEWCO C-Corp. The founders, however, would actually keep their NEWCO C-Corp shares inside of their retained S-Corp. Put another way, the founders will, therefore, own their QSBS C-Corp shares through their S-Corp ownership (with no upfront tax liability). If one were really trying to belt-and-suspender this, they might consider doing an asset appraisal of the transferred S-Corp assets to establish the cost-basis from which they would enjoy future QSBS tax treatment. The founders of one of our pending investments are going through this process now.
Another question one of my portfolio company founders asked in a recent board meeting is what happens in the case of a trade sale where the consideration is paid in acquiring company stock? In this case, QSBS status is retained, but the amount of Section 1202 gain is crystallized at the time of the exchange.
In this case, the employee purchases QSBS upon exercise of employee stock options. His sale proceeds are $5mm, and he paid $25,000 for the stock. Note that the 5-year clock (explained below) starts upon the exercise of the stock options, not the options grant date. Furthermore, the stock basis is the options strike price. In this case, the savings are $1.2mm or 100% tax savings.
Venture Capital Investors
In the example above, Investor 1’s tax basis is relatively low, and therefore the maximum Section 1202 exemption is $10mm, and the tax savings are $2.4mm or 70%. In the second investor example, the 10x basis calculation is higher than $10mm, so that is the maximum offset against the capital gain. The tax savings for Investor 2 are $4.8mm or 87%.
To illustrate the dramatic impact of QSBS – look at the returns math of Investor 2 with and without QSBS treatment. As shown below, when QSBS treatment is achieved, multiple of invested capital (MOIC) is 24% higher and IRR (assuming a 5 year holding period) is 12% higher.
Investors have a significant further benefit when it comes to IRC Section 1045. This allows investors to roll-over capital gain held for at least six months into new QSBS stock and keeps the clock running. The rollover into new QSBS must be made within 60 days. This provision is useful in the case where an exit occurs before the 5-year term, and also allows for the sale of subsequent QSBS before five years. Additionally, investors can benefit from the exclusion under IRC Section 1202 with respect to proceeds that are not reinvested, while making a 1045 election on proceeds that are re-invested. What an incredible benefit, especially for an evergreen venture capital fund such as ours!
At Cue Ball we seek to include commercially reasonable efforts covenants relating to QSBS in term sheets, stock purchase agreements, and investor rights agreements, when possible.
Eligibility Rules and Potential Foot Faults
Now that we have firmly established the considerable financial benefits of QSBS let us now turn to the eligibility rules. What follows is a high-level description, and your tax lawyer or accountant can provide you with detailed checklists with more granular detail.
- Issuing entity needs to be a US C-corp.
- Until the time of issuance, cash and other assets need to be less than $50mm. Note that if the company subsequently grows such that its assets are greater than $50mm, that does not jeopardize QSBS status of the previously issued stock. Stock issued after that does not qualify, however.
- Various active business requirements. Most notably, 80% of the company’s assets must be used to conduct the business.
- Must be a qualified trade business. Certain services businesses in health, law, or architecture, hotels, and restaurants, for example, do not qualify. Certain banking and insurance businesses do not qualify either. Technology businesses that are scalable would generally qualify, and these seem to be the intended beneficiary of the law.
Potential foot faults include:
- QSBS requires a 5-year holding period before sale. Note that for derivatives on stock, i.e., employee stock options, warrants, or convertible notes or SAFEs, the clock starts upon conversion into stock, not the grant date. This is a very common founder question. The assets test must also be satisfied at the time of the exercise date.
- Certain stock redemptions would trigger loss of QSBS status. Specifically, the company must refrain from redeeming stock from the taxpayer or related party two years prior to or after the issuance. Additionally, the company must refrain from redeeming stock worth more than 5% of the total value of the company one year before or after the issuance. Also, note that secondary purchases of stock are not QSBS eligible (because secondary deals are not new capital investment).
As mentioned upfront, the original goal of IRS Section 1202 and 1045 is to encourage new investment in startups. I am confident that this law has and will continue to be successful in this regard.
Note: I must state the mandatory disclaimer that I am not a tax lawyer or accountant, and this is not tax advice, and you should consult your tax lawyer and accountant for definitive advice on these tax matters.