When QSBS Isn’t Straightforward: Talking Through the Details

In a recent post we explored Qualified Small Business Stock (QSBS), an area of great interest in the Aumni investor community. We examined this under-reported topic with a panel of experts who partook in a special webinar roundtable on QSBS. This tax exemption is certainly one to note, as it can free early shareholders from paying substantial federal (and some state) taxes on long-term capital gains upon selling their shares. In our first post, we discussed the ins and outs of QSBS, who can take advantage and how. Next, we're diving into some thoughts on preparation and following the correct steps.

Supporting documentation and considerations

We asked our panel of experts for advice for high net worth individuals, GPS, funds, and family offices, specifically in terms of best practices for supporting documentation. We touched on the rep you can receive when you buy the stock and the covenant. But when one of your clients or when your fund’s partners are taking certain positions on QSBS, what is the best practice on supporting documentation to back up those determinations? It comes down to documenting your positions at the time of investment and at the time of exit as our experts discussed. Matt Parker, CFO of Greycroft, had this advice:

I spoke on some of those covenants we rely on, or the reps we rely on at a time of investment. We do a careful job of trying to monitor [them] throughout the life [of the investment] and really where it comes about next is during the time of exit because that's the tax year... We're going to need to make a determination and put it through to the K-1s...in the footnotes that it is QSBS. In order for us to feel comfortable giving the information that an investor would want to take and pull it through into their tax return, we have a questionnaire that we [ask] the company to reaffirm. Typically it's at that time the CFO will sign off and go through [it] with a fairly fine tooth comb, addressing some of the criteria around redemptions, the asset test, the fact that it was a qualified small business and all of the kind of IRS mandated criteria that they would want to see. We settle it through a questionnaire at the end. We pass along that information to our investors and ultimately let them make the determination if they take it or not.

Braughm Ricke, Founder & CEO of Aduro Advisors, shared another perspective:

A lot of times we won't have that kind of access to the companies to be able to get that questionnaire completed by the company itself. And, in our clients' cases, a lot of times we'll take that onus on ourselves, meeting the client directly. We have a questionnaire we'll go through with the client and check all those boxes and try to document as much as we can, both at the time of investment and where the company is at today, but mainly it's trying to look back at where the company was at that time of investment. [If the company] doesn't provide [documentation] that they qualify [for QSBS] at the time of investment, you try to go back and document that as much as you can, both from a values threshold perspective and all the other required metrics that need to be met. [Sometimes, we'll] complete that questionnaire along with the client and then work with the tax provider for that specific client to be comfortable with taking those steps.

Our expert QSBS panel also explored what happens when you don’t have access to any paperwork. There may be times when you have meaningful positions in a company, giving you access to a lot of information with deals. However, for some small or seed funds, or angel investors, getting access to financial statements can be very challenging. For that segment of the market, look to the rep and the covenant and if you can't rely on access to financial documentation, it is beneficial to consider what other types of information can be obtained and what the best practices indicate among earlier stage funds. Braughm shared:

With limited information, there's really limited documentation that you can access. It really is just going back and looking at the documents at the time of investments and pulling anything that you can from that aspect. But it's very difficult because [with a company such as] Uber or something like that, where they're extremely tight about providing any information, there really isn't that much to point to. So it really is balancing the comfort level of the client and the comfort level of the tax provider as to how much risk they're willing to take on in terms of attesting to it themselves, as opposed to relying on the company.

Create clear and consistent definitions.

Furthermore, with QSBS, consistent definitions are paramount, especially when it isn’t so clear around types of common, early stage investment vehicles or instruments (such as safes or convertible notes). Lindsay Chamings, Managing Director at Andersen, noted:

A lot of the issues that we run into on the fund side have to do with the treatment of these different instruments when the holding period starts: when you've got a warrant, when you've got a convertible note, when you've got a safe and how that plays into different ideas about warehousing securities [and] contributing them to partnerships. I think the rules [with 1045]  clearly say that you lose your QSBS when you do that. So if you've got an instrument that's not 100% clearly defined that you contribute in, does that mean that instrument still might qualify when it eventually is exercised or converted? [QSBS parameters were written] before safes were really an instrument that [businesses] used and there aren't really other provisions in the law that address safes that we can pull into this to try to figure out how they would be treated. So, it's the Wild Wild West, and you could probably make an argument in either direction.... As an individual, as a firm, you'd probably want to be consistent with that argument, but I guess from person to person, firm to firm, you could vary greatly on what you decide to do with safes.

QSBS is a very valuable tool, but it isn’t something to enter into without careful consideration. Taking proper documentation and consistently defining your investment can help in your dialogue with the company and your tax professionals. Another element to keep in mind is that there are some gray areas with QSBS. The next and final installment in our QSBS series will dive into precisely this sphere and cover what details to pay special attention to when the borders get blurred.