Corporate & Securities Blog

‘Does QSBS Apply?’: An Introduction to Qualified Small Business Stock

One question we consistently receive from both startups and venture capital investors is whether qualified small business stock (QSBS) applies to a structure. They may have previously experienced the benefits of QSBS first-hand or have seen headlines such as the New York Times’ “A Lavish Tax Dodge for the Ultrawealthy Is Easily Multiplied – The New York Times” or Businessweek’s “When an Eight-Figure IPO Windfall Can Mean a Zero-Digit Tax Bill.”

This article is intended to provide an overview of QSBS, its usage and some general planning observations based on our experience in this area.

What is QSBS?
QSBS, or Section 1202 stock, generally:

  • Is issued by a C corporation after 1993.
  • Is acquired by a non-corporate taxpayer at original issuance.
  • Is held for at least five years.
  • Meets certain requirements consistent with the C corporation being a small business, including:
    • The business’s gross assets cannot exceed $50 million at any time before the issuance.
    • At least 80% of the assets of the business must be used in a qualified, active business (non-qualified businesses generally include service-related businesses, including services in the fields of health, engineering, financial services, law, consulting, performing arts and others).

 

Why QSBS?
The primary benefit of owning QSBS is that upon the sale of the stock, a shareholder can exclude up to $10 million of gain (or, if greater, 10 times the shareholder’s basis in the stock). If a taxpayer would otherwise be taxed at a 23.8% rate on that gain, the tax savings from owning QSBS would be $2.38 million.

There are further tax planning opportunities with respect to gifting (to be able to utilize the exemption several times among family and friends) and rolling over stock to another qualifying C corporation.

Planning and Pitfalls: Some Highlights
Below is a short list of planning observations based on our client representation in this area:

  • Election: The QSBS tax exclusion must be elected; it does not automatically apply.
  • A 28% rate for gains outside the exclusion: If a gain is large enough such that there is still further gain after the full QSBS exclusion is applied, the remaining gain would be taxed at a capital gains rate of 28%, even if it would otherwise be taxed at a long-term capital gain rate of 20% if no QSBS exclusion were applied. Hence, it may not always be advisable to elect to apply the QSBS exclusion on a sale.
  • Exchanges for stock: Original issuances by the C corporation in exchange for stock do not qualify for QSBS treatment.
  • Redemptions: Original issuances by the C corporation also do not qualify for QSBS treatment if the C corporation has made significant redemptions within a certain two-year testing period or if the shareholder at issue has had the C corporation’s stock redeemed within a certain four-year testing period. The tests related to redemptions can be complex due to related party rules, de minimis rules and certain other exceptions.
  • Working capital exception: There is an exception to the 80% test described above for working capital. In the aftermath of the failure of Silicon Valley Bank and other bank failures, in addition to seeking to diversify banks in which companies have cash deposits, some companies have reimagined their business models and questioned whether they should pursue alternatives to cash deposits. Owning mutual funds or minority stakes in portfolio companies would generally not qualify for the working capital exception and could result in jeopardizing QSBS status.

 

The Road Ahead
While QSBS has been part of the Internal Revenue Code since 1993 and has been used in the venture capital community for years (particularly after a 2010 change in law resulted in an exclusion of 100% rather than 75% of the applicable gain), its utilization has become more widespread since a 2018 income tax rate reduction for C corporations (21% rather than 35%) made QSBS even more attractive. As a result, we are now seeing an increase in case law and guidance as audits and ruling requests proceed. In recent months, we have seen case law emerge on a conversion from a limited liability corporation to a C corporation and guidance from the IRS regarding what constitutes a qualified business for QSBS purposes. Stradley Ronon is continuing to monitor developments in this important space for startups and their investors.

 

About the Author

Dean Krishna

Dean V. Krishna concentrates his practice on international and domestic tax matters. He advises on matters including mergers and acquisitions; private fund agreements, investments and structuring; commercial securities offerings; business restructurings; and general domestic and cross-border tax planning.

dkrishna@stradley.com
215.564.870

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