Among the many issues on the minds of founders and executives at early-stage or pre-seed startups is the ability to issue qualified small business stock (QSBS or Section 1202 Stock). This topic is critical because it affects a company’s ability to raise capital to grow its business. It also affects investors’ ability to exclude capital gain realized on the sale of stock if the requirements of section 1202 are met.

With that in mind, I will channel my inner David Letterman and share my top 10 list of things to do or not do to preserve QSBS treatment for stock already issued and for stock to be issued in the future. If you want a quick overview of the rules governing QSBS, you can read about them here.

So let’s get right to it and discuss the top 10 things to look out for in order to preserve QSBS treatment.

  1. Redemptions – If a company purchases its stock from a shareholder, the redemption can destroy QSBS treatment for the redeemed shareholder and for all other shareholders. Yes, you read that right – one redemption can destroy QSBS treatment for ALL shareholders, which is why redemptions are at the top of this list. A redemption can affect stock issued to the redeemed shareholder (and persons related to such shareholder) in a 4-year window period beginning 2 years before the redemption and ending 2 years after the redemption, and it can affect stock issued to all other shareholders in a 2-year window period beginning 1 year before the redemption and ending 1 year after the redemption. There are exceptions for de minimis redemptions, for certain redemptions issued to retired or terminated employees or directors, and for redemptions in connection with the death, divorce, disability, or mental incompetency of the redeemed shareholder. These rules are complex, and tax counsel should be consulted before any redemptions are executed, particularly for redemptions designed to take out one or more founders early in the venture.
  2. New Businesses - A company issuing QSBS must be engaged in a qualified trade or business (QTB) for substantially all of the selling shareholder’s holding period of the stock for which QSBS treatment is sought (the Active Business Requirement). The definition of a QTB is broad, but there is a lengthy list of excepted businesses. The Active Business Requirement presents an issue when a company engaged in a “good” business seeks to expand into a “bad” business, such as an insurance company. The Active Business Requirement will not prevent the expansion, per se, but care must be taken to ensure that the value of the assets used in the “bad” business does not exceed 20% of the value of the company’s total assets.
  3. Working Capital and R&E - The Active Business Requirement mandates that for substantially all of the selling shareholder’s holding period, at least 80% of the value of a company’s assets must be used in the active conduct of a QTB. This includes assets (i) that are held as part of the reasonably required working capital (WC) needs of the business and (ii) that are held for investment and are reasonably expected to be used within two years to finance research and experimentation (R&E) expenses of a QTB or increases in WC needs of a QTB. However, after the company has been in existence for two years, amounts set aside for the above two purposes cannot exceed 50% of the company’s assets. Typically, this is not an issue for nascent businesses, but it can create an issue after one or more significant capital raises. This is something that needs to be monitored on an ongoing basis.
  4. Real Estate and Portfolio Stock – Another aspect of the Active Business Requirement is that a company cannot hold more than 10% of the value of its assets in real estate not used in a QTB or in stock of another company where it is not a majority shareholder (portfolio stock). If this occurs, the company will not be considered to meet the Active Business Requirement during the period in which the relevant 10% threshold is breached.
  5. M&A – Companies that engage in mergers, acquisitions, dispositions, reorganizations, spin-offs, etc., should consult with tax counsel before any such transactions are executed because the amount of future gain eligible for the QSBS exclusion can be limited to the amount of gain that existed as of the transaction date.
  6. Partnerships and S Corporations -If a partnership or S corporation acquires QSBS from the issuing company, then the partners or shareholders of the partnership or S corporation generally are eligible for QSBS treatment when the partnership or S corporation sells the QSBS and allocates eligible gain to them. Significant limitations apply to partners or shareholders who join the relevant entity after it acquires the QSBS and to partners or shareholders that increase or decrease their interest in the relevant entity after the acquisition of the QSBS. Another caveat is that partners or shareholders are not eligible for a QSBS exclusion if they sell their interest in the partnership or S corporation, even if the only asset in the entity is QSBS.
  7. Estate Planning – Shareholders need to be careful about transferring QSBS to a partnership, LLC, or corporation as part of their overall estate plan. The estate planning advisor may have great ideas to save on estate and gift taxes, but unless they are knowledgeable about and sensitive to QSBS tax issues, problems can arise, and QSBS treatment can be lost permanently. All transfers of QSBS should be discussed with tax counsel familiar with the tax rules affecting QSBS. Not all estate planners know these rules, so make sure to ask the question before effectuating any estate plan involving QSBS.
  8. 5-Year Holding Period – Shareholders must hold their stock for more than 5 years to be eligible for QSBS treatment. All is not lost if the stock is sold before 5 years, but planning will be required. If you are in this situation, consider reading my previous article, “I Sold My Small Business Stock After 4½ Years – Can I Qualify for the QSBS Exclusion?”.
  9. Hedging – Shareholders should not hedge the value of their QSBS in any manner without consulting tax counsel. Generally, this is not an issue for shareholders in private companies because there is no active market to hedge the value of the stock.
  10. S corporation Distributions - If an S corporation acquires QSBS from the issuing company, then it should not distribute the QSBS to its stockholders without consulting tax counsel. Such distribution can eliminate the ability of the stockholders to qualify for a QSBS exclusion.

The rules governing QSBS are complex and there is no substitute for timely and independent advice from a qualified tax advisor. Even if you are speaking to a tax lawyer or tax accountant, make sure to ask if they are well-versed in the specific rules governing QSBS.

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For more information on this topic, please contact a member of Withum’s Business Tax Services Team.