Be Careful What You Ask for – Inexpensive QSBS Advice Is Not Always Helpful

We are seeing an increasing number of entrants in the market offering advice regarding qualified small business stock (QSBS). The advice can be informal, but often it comes in the form of opinions, memos, or attestations. Some providers offer their services for unusually low fees, and some suggest the need for annual updates. Sometimes the providers offer quality advice for low fees, and other times they offer boilerplate advice with little value.

Strangely, one of the documents I reviewed concluded that an issuer’s stock was QSBS but then included a disclaimer that it was not offering tax advice. Huh? If it’s not tax advice, then what is it?

So what is required of issuers and holders of QSBS before stock is sold and an exclusion is claimed? Nothing, actually. Let me explain. But first, a general overview of section 1202, the section of the Internal Revenue Code that gives us QSBS.

Section 1202 provides a full or partial exclusion of capital gain realized on the sale of QSBS that is held for more than 5 years. There are various requirements in order for stock to constitute QSBS – there are some that apply to the Company that issued the QSBS (company-specific requirements), and there are some that apply to the shareholder that is selling the QSBS (shareholder-specific requirements). If all of the requirements are met, then the selling shareholder can exclude from gross income capital gain in an amount equal to the greater of (i) a cumulative per-issuer amount of $10 million or (ii) an annual exclusion of 10 times the basis in the stock sold (for an exclusion amount up to $500 million). There are also specific tax strategies, like stacking and packing, that enable shareholders to magnify their QSBS tax benefits.

The exact exclusion percentage depends on the date when the selling shareholder acquired the stock from the Company, rather than the date on which the stock is sold. The percentage options are 50%, 75%, and 100%, with the latter being applicable to QSBS acquired after September 27, 2010. No stock issued before August 11, 1993 can qualify as QSBS.

Technically, companies issuing stock do not need to provide any information to their shareholders regarding tax issues, but when it comes to QSBS, companies must agree to provide certain information to the IRS and to their shareholders regarding the company-specific requirements. Practically, most companies informally (and often formally) notify their shareholders that their stock can qualify for QSBS if the shareholder-specific requirements are met. Companies usually do this through a factual certification that affirms compliance with some or all of the company-specific requirements, but they also advise shareholders that their affirmations do not constitute tax advice (which makes sense – QSBS issuers are not in the business of providing tax advice). Companies also may choose to notify prospective investors that their stock can qualify as QSBS, and provide similar factual certifications, and often they state that they intend to operate their businesses in such a way as to maintain QSBS eligibility. These forward-looking statements are necessary because many of the company-specific requirements are required to exist for “substantially all” of the shareholders’ holding period in the stock.

For shareholders, nothing needs to be filed with the IRS until QSBS is sold and the shareholder claims an exclusion from gross income on his or her tax return that includes the year of the sale. Practically, shareholders want to know if they hold QSBS when the stock is acquired or at some point thereafter but before the stock is sold. When people hear about a tremendous tax benefit like QSBS, they want to know if they qualify as soon as possible. It’s similar to the sentiment expressed by Harry in the 1989 movie When Harry Met Sally – “when you meet the person you want to spend the rest of your life with, you want the rest of your life to start as soon as possible.”

We are often approached by companies and shareholders seeking advice as to whether their stock is QSBS. This makes sense. Companies want to help their founders and major shareholders obtain a tax benefit, and shareholders want to know if they will obtain a tax benefit when they sell their stock. Sometimes our advice takes the form of a short phone call, and other times it takes the form of a detailed 25+ page memorandum examining the requirements of section 1202 and how it applies to the specific facts of the company and the shareholder. In most cases, our written guidance is intended to constitute “advice” that can be relied upon for penalty protection in the event of an IRS audit.

The recent QSBS advice we are seeing from some providers is concerning. In some cases, the advice contains boilerplate confirmation that certain of the rules are met, but it provides no factual description or explanation of how or why the rules are met. Sometimes, less than all of the relevant rules are discussed. Sometimes, there is a disclaimer that the document does not constitute tax advice. Sometimes the advice is wrong or fails to consider facts that negate QSBS treatment. And rarely, if ever, does the advice address state tax treatment; not all states conform to section 1202.

Clients like the advice because it is inexpensive. We get that – who doesn’t like a deal, especially when it comes from a reputable company (reputable in a non-tax context, that is). But it is inexpensive for a reason – the reason is that the provider is not delving into the facts and applying them to the requirements of the Internal Revenue Code.

In one case, the provider concluded that a company’s stock was QSBS. When I explained to the shareholder who shared the document with me why he could not rely on it, he went back to the provider. It disagreed at first. When I explained to the shareholder, and he explained to the provider, the specific reason that the company was not eligible to issue QSBS, the provider did not know the answer and said it needed to consult with its outside counsel. Two weeks later, the provider agreed the company was not eligible to issue QSBS. I’m not saying that every provider gives incorrect advice, but this was a well-known market participant, and its boilerplate advice did not consider all the nuances that apply to QSBS.

There are many firms that can provide quality advice regarding QSBS, and not all of them are accounting and law firms. But QSBS is a tax concept, and taxpayers are well advised to seek tax advice from a specialist in providing tax advice. And preferably from one that specializes in QSBS. Would you consult anyone other than a licensed dentist on whether you need to have a tooth removed? Of course not. Don’t be penny-wise and pound-foolish. Sometimes a good deal is a good deal, and other times it is not. Consider the source of the advice and the magnitude of your potential tax benefit before choosing the provider that is right for you.