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Top 10 Things To Preserve Qualified Small Business Stock Treatment

Written by Daniel Mayo, Principal

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...

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Thanks to OCSC Silver Sponsor Armanino LLP for this information about Qualified Small Business Stock (QSBS) tax issues:

Qualified Small Business Stock (QSBS)

There are many reasons we’re currently seeing so many inquiries and requests for assistance around QSBS.

• Numerous companies undergoing funding rounds –investors are demanding QSBS information.
• Increase in secondary offerings.
• Requests in spinoffs inquiring about qualifications.
• More reorganizations and conversions from LLC, where QSBS can be of benefit.
• Consistent number of liquidity events are ongoing, and knowledge in this common risk area is limited; experts are needed to support companies throughout transactions.

The benefits of qualified small business stock (QSBS) were enhanced during the passage of the 2015 Protecting Americans from Tax Hikes Act, and unaltered in the Trump TCJA reform.

What does that mean? It means QSBS is still here – and here to stay (for the near term). Congress has clearly shown a desire to proactively incentivize more investment in small business, progressively increasing the amount of maximum exclusion, now inclusive of the 3.8% net investment income tax.

Are you overlooking significant tax savings in QSBS?

If you were a founder, employee or investor of an early-stage company, you need to be aware of the significant tax benefits of Section 1202, QSBS. In addition, IF your Company is QSBS qualified, your Shareholders would be most interested.

If you have held QSBS for at least five years, a portion of your gain or, in some cases, all of your gain upon sale may be excluded from federal income tax. An exclusion of up to $10 million or 10 times the taxpayers adjusted basis in the stock (time scales exist to calculate the exclusion) with any residual gain taxed at capital gain rates. Moreover, there are favorable rollover and deferral opportunities (under Section 1045) if QSBS gains are invested into other QSBS entities. Attention should be afforded to State(s) compliance and conformity.

How do you qualify for QSBS treatment?

The requirements for a company to qualify as a Qualified Small Business are detailed and require some analysis. At a very high-level, the following are needed to qualify:

• A domestic C-corporation
• Satisfaction of asset limitation analysis
• Qualified trades or businesses, other than services firms(e.g., brokerage, health, engineering, consulting, etc.)
• An entity that is an active trade or business, as defined
• Originally issued and owned Stock
• Stock held in a company without certain disqualifying redemption transactions

The rules for qualification are complex and companies need to engage professionals who can assess qualification and timelines to assure QSBS status. Armanino has professionals who have been supporting companies around Section 1202 and 1045, and we work with not only the companies but executives and the investment community to assure maximizing the benefits.

Why Armanino? 

For more than 50 years, we have focused our tax practice to meet the needs of growing companies – and we understand one size doesn’t fit all. We pride ourselves on a tailored approach specific to your needs. We ask the right questions and we listen. In addition, we believe a consistent engagement team year over year is critical to client satisfaction

Highlights of Our Tax Practice

Tailored services to meet your specific tax, accounting and growth goals.

Integrated and tenured engagement team led by Senior Partners who act as part of your day-to-day team. You’ll work with a consistent, independent, and proficient tax team who understands all GAAP & government compliance requirements.

Lower cost structure, with the depth/breadth to deliver the services you need – without the red tape of much larger firms.

International reach through membership in Moore Global, one of the world's major accounting and consulting membership organizations.

Quick responses to match your tight deadlines. Our work processes are streamlined, and we know that service does not start at 8AM or end at 5PM.

Sample Corporate Tax Clients

Our experts make the tax function a key component of your business strategy. Some of
our notable tax clients include:

• Coinme
• MarkLogic 
• Silicon Labs
• Better Therapeutics
• Immersion
• Copart
• OpenTable
• Twitch

Need to learn more? Contact us!

We have assisted many companies, their employees, and investor base (including VC firms) around education of QSBS and QSBS tax implications, including tailored education around all forms of company equity arrangements such as ISOs, NSOs, ESPS, RSUs, Stock Grants, 83(b) understanding, tax treatments for the variety of issuances, and tax planning considerations.

Our team can walk you through QSBS and assist your Company in developing a position for those shareholders that inquire on the qualifications under Section 1202.

For next steps on how we can support you and your team, contact one of our experts:

Tom Bondi, CPA
Partner, Tax
Tom.Bondi@armaninoLLP.com
408 494 1254

Peter Klinger
Partner, Compensation & Benefits
Peter.Klinger@armaninoLLP.com
925 790 2806

In Orange County contact Ian Martini to learn more about how Armanino can help your growing company.

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