QSBS – The Gift That Keeps on Giving

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:

QSBS.

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.