QSBS – The Gift That Keeps on Giving
Dave Reed — March 24, 2022
This is it. The moment has come. Sit down, take a deep breath and give yourself a pat on the back. Years of long hours, sleepless nights and self-sacrifice has finally paid off. The company you poured your life into was barreling down the path to a summer IPO when you received a strategic acquisition offer that you can’t resist. But should you? If you do, what are the tax implications and what can you do to minimize your tax bill?
Most founders probably don’t jump straight to the tax leakage conversation when faced with the prospect of an exit. If they did, I would chime in to remind them of four of the sweetest letters in the tax code:
Section 1202 of the Internal Revenue Code provides owners of “Qualified Small Business Stock” the ability to pay zero tax on the first $10m of capital gains associated with qualifying stock. For founders, this can mean saving millions in actual tax dollars. For fund managers like PowerPlant, the benefits are even greater. That is because the rules apply to each individual stockholder and the typical fund partnership structure is a pass-through entity. This means that each limited partner could separately exclude up to $10m of gains.
Yes, there are a lot of hoops to jump through but don’t let that deter you as the potential savings are 100% worth it. The rules are nuanced so without getting too deep into the details, the main criteria that need to be met are:
>The stock must have been issued after August 10, 1993 (September 27, 2010, to get the full $10m exclusion) in a domestic corporation with less than $50m in gross assets in exchange for value received or as compensation for service rendered.
>The corporation must conduct an active trade or business during the entire period the stock is held, and no more than 10% of the corporation’s net assets can consist of real estate investments or the stock and securities of other corporations.
>The stock must be held for a period of no less than five years at the time of sale.
>The corporation must not have redeemed a significant amount of its stock within the two-year period before or after the issuance of the stock.
>If you think you may have purchased QSBS stock, the first place to look is your stock purchase agreement. Most SPAs of early-stage VC/PE backed companies include boilerplate language on the corporation’s QSBS status as of the time of the financing. If the language is there, you know the shares were QSBS eligible at the time of issuance, but you still need to ensure that the company maintained eligibility throughout the entire holding period.
You may have shares that are QSBS eligible and not even know it. Many people falsely assume that shares are ineligible for certain transactions that occur before the five-year mark, but there are exceptions to the rule. Here are a few examples:
Fund Distributions in Kind
You are a limited partner in a fund that invested in QSBS eligible shares. The company went public four years after the investment was made and six months later the Fund sold 100% of the shares. The sale of the shares “inside” the partnership creates capital gain that flows through the fund to the investors for inclusion on their personal returns. Those cap gains would not qualify for exclusion because the shares were not held for five years at the time of the sale.
If instead, the fund distributed the shares to its partners, rather than selling them inside the partnership, investors could “tack” their holding period to the fund’s holding period. If investors hold the shares for at least six months post-distribution, the shares will meet the holding period requirement and gain can be excluded.
Mergers & Acquisitions
You are a fund manager and a board member of a small QSBS eligible company being targeted for acquisition by a public company. The term sheet outlines an offer to acquire 100% of the stock of the QSBS company in exchange for stock of the public company acquirer. The offer is good but not great and the board can’t get a consensus on whether to accept it. The investment was made almost five years ago, and you don’t want to lose out on QSBS treatment by taking a deal this close to the finish line.
Good news! If the transaction qualifies as a tax-free reorganization under sections 351 or 368 of the IRC, any non-QSBS stock received in exchange for shares that are otherwise QSBS eligible will become QSBS eligible so long as the other requirements continue to be met. The fund could hold the public shares until the five-year holding requirement was met and then sell or distribute QSBS stock to its investors.
The moral of the story is that even if a company has an “exit” before five years that doesn’t necessarily mean the shares you received won’t qualify for this incredible tax-saving opportunity. With the ability to survive IPOs, pass-through fund structures, and even convert non-QSBS eligible shares received in M&A transactions into QSBS shares, Section 1202 of the IRC truly is the gift that keeps on giving.
More gifts by Dave Reed, here.