If not, then the 5-year clock will not begin until the SAFE converts to equity, which may not occur until many years after acquisition of the SAFE. The characterization of a SAFE as stock for tax purposes is also relevant to rollovers under section 1045, which permits taxpayers to defer and to rollover capital gain in cases where the holding period requirement of section 1202 has not been met.
Unfortunately for investors, there is no guidance from the IRS on whether a SAFE constitutes stock, and the available authorities are not clear on whether a SAFE should be treated as stock for purposes of section 1202. This article will explore the factors relevant to this determination.
SAFEs, or simple agreements for future equity, were introduced by Y Combinator in late 2013 as a replacement for convertible debt. They are a popular way for early-stage start-ups to raise capital and are often preferred over convertible debt because they bear no interest, have no maturity date, and convert into equity only if certain predetermined criteria are met.
Y Combinator provides model agreements and a user guide that can be downloaded from its website. These templates can be adopted as written or modified at will to suit the parties’ needs. In a typical SAFE, the investor provides funding to the issuer in exchange for the right to acquire equity in the future upon the occurrence of a triggering event, such as the completion of a priced round of equity financing, sale of the company, or dissolution. It is fully prepaid and the investor has no funding obligation beyond the purchase price paid for the SAFE. The SAFE terminates after it converts to equity.
Read our article discussing the tax treatment of SAFEs and convertible debt for more information about the uses, tax treatment, and tax characterization of these instruments.
Section 1202 is one of the most powerful gain exclusion provisions in the Internal Revenue Code. It provides for the full or partial exclusion of capital gain realized on the sale of qualified small business stock (QSBS) that is held for more than 5 years. If the requirements are met, then taxpayers can exclude from gross income capital gain in an amount equal to the greater of (i) $10 million, or (ii) an annual exclusion of 10 times their basis in the stock sold (for an exclusion amount up to $500 million). Both of these limitations apply on a per-issuer and per-taxpayer basis, and while the rules limit the exclusion to the greater of the two rules, in practice, the $10 million rule is most often the limiting factor in start-up ventures.
Read our article discussing the requirements of section 1202 and some guidance that was recently issued by the IRS.
Section 1045 is a provision related to section 1202. Section 1045 allows taxpayers to sell QSBS and to defer capital gain on the sale if they roll the sales proceeds into replacement QSBS within 60 days of the sale. This allows for the deferral of existing and future capital gain until the sale of the replacement QSBS.
Read our article discussing section 1045 and the requirements of that section.
Now let’s turn to the issue at hand – does an ownership interest in a SAFE qualify as “stock” for purposes of section 1202?
An exclusion under section 1202 is predicated upon a sale or exchange of qualified small business “stock.” The meaning of stock for this purpose includes “any stock in a C corporation” and this includes common and preferred stock, and voting and nonvoting stock. It does not include stock in an S corporation or rights to acquire stock in the future, such as a prepaid forward contract, an option, or an interest in a deferred compensation arrangement that is designed to result in future stock ownership (e.g., incentive stock option or nonqualified stock option). This article discusses only whether a SAFE is stock for purposes of section 1202, and it does not address other tax characterizations because section 1202 requires stock ownership and nothing else will suffice.
An ownership interest in a SAFE is not the same as an ownership interest in common or preferred stock. For starters, an investor in a SAFE owns no shares of stock, has no voting rights, and has no power to sell stock to a third party because the investor can’t convey what she doesn’t own. Section 5(c) of the model SAFE agreement states that the investor is not entitled to be deemed a holder of capital stock for any purposes other than tax purposes, and that the SAFE confers no rights of a stockholder. It is not clear that taxpayers can selectively designate themselves as stockholders for some purposes but not other purposes. The IRS has blessed disparate treatment for certain hybrid instruments, but the characterization in those instances generally involved different debt/equity treatment for US and non-US tax purposes. See, e.g., TAM 200418008 (December 29, 2003) (“foreign law characterization of the instruments has little or no weight because Country 1 and the U.S. use different standards for classifying instruments as debt or equity”). In the purely domestic context, when taxpayers attempt to structure instruments as debt for tax purposes but equity for regulatory, rating agency, or financial accounting purposes, the IRS has announced that it “will scrutinize instruments of this type” and analyze “the cumulative effect” of the features of the instrument. See Notice 94-47 (April 18, 1994); see, e.g., CCA 200932049 (March 10, 2009) (respecting debt for tax purposes even though treated as equity for regulatory and rating purposes).
An investor in a SAFE also has no right to distributions that are made to a holder of common stock, but if there is such a distribution of property, then section 5(c) of the model agreement provides that the investor may be entitled to a dividend-equivalent amount at the same time. Section 5(d) provides that an investor in a SAFE generally may not transfer or assign the SAFE without the prior written consent of the issuer.
SAFEs do have some similarities to stock. For example, if there is a liquidity event or dissolution event before termination of a SAFE, then section 1(d) of the model agreement provides that an investor has rights similar to standard non-participating preferred stock. Also, if there is a liquidity event, then section 1(b) provides an investor with participation rights similar to holders of common stock. But these rights, standing alone, mostly likely would not be sufficient to sustain the position that a SAFE is stock for purposes of section 1202.
If an investor’s interest in a SAFE is not actual stock, and a SAFE does not entitle an investor to the bundle of rights typically associated with stock, then can a SAFE still be considered stock for purposes of section 1202? The model agreement contemplates this and section 5(g) states as follows:
Even though this provision can bind the parties to treat a SAFE as stock for tax purposes, it is not binding on the IRS. The IRS is free to challenge the characterization of an instrument for tax purposes. But an investor in a SAFE hoping for stock treatment would have a weaker tax position if the issuer did not agree to this provision and treated the SAFE as something other than stock for tax purposes.
Another important factor in the characterization of a SAFE is whether the SAFE is substantially certain to convert into stock as of the date the SAFE is issued. In a different context, the IRS ruled that an option or convertible note can be treated as stock if the option or convertible note is substantially certain to be converted into stock. See, e.g., Rev. Rul. 82-150 (corporation that acquires for $70 an option with an exercise price of $30 to acquire stock worth $100 “has assumed the benefits and burdens of ownership” of the underlying stock and therefore is treated as the actual owner of the stock); Rev. Rul. 83-98 (convertible notes purchased for $1,000, worth $600 at maturity, and convertible at any time into stock currently worth $1,000 are treated as stock because of “the very high probability” of conversion into stock).
If a taxpayer takes the position that a SAFE is stock for purposes of section 1202, then the conversion of the SAFE into stock of the issuer will not effect on the 5-year holding period because the stock acquired is treated as having been held during the period that the SAFE was held.
There is no clear guidance on whether a SAFE constitutes stock for purposes of section 1202, and the IRS is unlikely to issue guidance on this point in the near future. Practically, this means that investors will have to rely on advice from a qualified tax advisor. But the investor (and not the advisor) is the one taking the position on her tax return, and she needs to be comfortable that the position is sustainable and will not subject her to penalties if successfully challenged by the IRS. Thus, if an investor has a relatively low level of comfort (e.g., reasonable basis — about 20% possibility of success), but wants to take the position that her interest in a SAFE is stock, then she should consider affirmatively disclosing the position on her tax return to avoid penalties. The downside of this approach is that the filing of the disclosure form (Form 8275) is almost certain to invite IRS scrutiny. Conversely, if an investor has a higher level of comfort (e.g., substantial authority, more likely than not, or should), then disclosure generally is not required. Ultimately, the determination of whether a particular SAFE constitutes “stock” for purposes of section 1202 requires a detailed analysis of the facts and the determination should be made in consultation with a qualified tax advisor. If an investor wants 100% certainty on this issue, she will need to invest in stock rather than in a SAFE.
If you have questions regarding SAFEs or section 1202, please reach out to your Withum advisor.