Qualified Small Business Stock: Who Qualifies and How to Take Advantage of the Tax Savings

We’ve been getting a lot of interest from the Aumni investor community in a topic that’s not broadly discussed in the private capital markets: the Qualified Small Business Stock, or QSBS – a tax exemption that frees early shareholders from paying federal (and some state) taxes on long-term capital gains upon selling their shares. The tax break applies to up to $10 million (or 10 times your cost basis, whichever is greater) from federal taxes. The catch is that not all small businesses qualify for QSBS. There are very specific criteria as to how the company is set up. Aumni recently held a webinar with an expert panel to drill into this topic, starting with how a startup would qualify for QSBS. 

First of all, to qualify for QSBS a startup must be set up as a C corporation and it must create goods (as opposed to services), such as technology. Aumni webinar panelist, Ryan Gaglio, Attorney and Shareholder at Stradling Law, had some great examples to help illustrate the big picture here:

“The purpose of QSBS from an intellectual perspective is to get money into qualified small businesses. Qualified small businesses cover a broad range of industries that [make] things as opposed to [provide services, such as law firms, medical offices, or accounting firms.] If it relies on the reputation of a single person, that would not be a qualified small business. We're looking at businesses that employ people that build things and the purpose is to get money into those businesses.”

Another key piece of criteria is that, as an investor, you must receive shares when the company’s gross assets are $50 million or less. Furthermore, the startup must use 80% of its assets for business operations. Ryan explains:

“An area that there is often a lot of discussion about is related to moves of cash out of the business, redemptions and things like that. Generally, qualified small business stock is acquired and original issuance with cash going into the business to fund operations of the business, as opposed to back out the door to existing investors or a liquidity event for founders.”

In order to take advantage of the exemption there are a few parameters. Investors must have acquired the stock directly from the issuing company for either cash, services, or property (including IP). So if shares are acquired through a secondary transaction they would not qualify. Additionally, the shareholder must also be a non-corporate taxpayer. Lastly, there’s typically a five-year holding period before stock can be sold. Ryan notes:

“If you meet all of those different requirements, then as an investor you get a pretty powerful benefit, which today is an exclusion for the first effectively $10 million for a married couple, a complete exclusion of the gain on that from a federal level. It's a pretty dramatic savings at today's rates federally -- call it 20-23% on the first $10 million. This is a $2.3 million savings.”

The QSBS benefits are applicable at the early stage of a business, and hence they are of most value to early stage investors. But there are some “trip ups” that can get in the way of reaping those benefits. Lindsay Chamings, Managing Director at ANDERSEN, cautioned investors to closely watch how the capital is being used:

“One of the issues that we see becoming a problem is related to subsidiaries. When you're looking to determine whether it's an active trader business all the assets have to be used in what the active business is. If you have subsidiaries their assets can only be included in that calculation if you own more than 50% of them. So, if as a company you make an investment into another company, that's less than that percentage, then that's considered to be stock. When you have portfolio investments that can impair whether or not you have an active trader of business, but then you have to layer into that. The idea of having the active trader business is for substantially all of your holding period. People can make mistakes and trip this up if it's intermittent, and if it's somehow resolved. It can be quite tricky and ‘substantially all’ isn't a perfect definition. I think a lot of times we use 80% as being what ‘substantially all’ is.”

Ryan Gaglio also noted that one of the items that can be a bad asset for QSBS is cash:

“Cash is a good asset to the extent that it's for your working capital needs. And there's some guidance around that being something that you can use within a two year period. [However] I have seen instances of a down round coupled with a large infusion of cash where you start to question, ‘Do they have too much cash on the balance sheet? Does all of this extra cash really exceed what the company needs for its working capital purposes?’ And then you get into a much harder factual discussion, which is, ‘How much working capital does a business need?’  And in the circumstance of the down round, you didn't know you're facing maybe some other economic headwinds, you can start to question, ‘Is this just too much cash on our balance sheet?’ And that could cause an issue for qualified small business stocks.”

Matt Parker, CFO at GREYCROFT, made a key distinction that it’s critical to track that a company qualifies not only when making the investment but also on a continual basis:

“We track both the companies and investments that we make that qualify at the time we make it and then monitor them throughout our life cycle to ensure that we don't blow that investment. We actually ask that the company qualifies at the time that we're making the investment and that's in the stock purchase agreement generally, which is part of the standard NVCA legal documents, which we like to use.”

He also mentioned going beyond the National Venture Capital Association (NVCA) documents by adding a covenant in the investor rights agreement that ensures that the company continues to qualify, and ensure it is documented at each round of financing.

The panel spoke about a great deal of considerations on the subject of QSBS and related investment vehicles. One element is clear: QSBS is worth exploring for its attractive tax savings. However, it is not always a simple equation, as there are many nuances. Founders, investors, and early startup employees who wish to utilize QSBS should engage the right professionals for advice. A theme that kept recurring throughout the discussion was that of gray areas, which is the subject we will tackle in our next post.