Preserving QSBS During Banking Turmoil

Upon the collapse of Silicon Valley Bank, First Republic Bank and other banks during 2023, many companies moved cash which may pose risks for QSBS eligibility in various ways. 

Excess Cash or Other Holdings (perhaps from drawing down on lines of credit) may cause a company to fail the Active Business requirement whereby at least 80% of the company’s assets must be used in the active conduct of a qualified trade or business. 

• For purposes of this test, several limitations and exceptions apply:
  • During the formative years of a corporation, certain assets used to start-up the venture, including some research and development activities, are treated as active business assets in satisfying the Active Business Requirement. (1202(e)(6))
  • Assets that are held to meet the reasonable working capital needs (“Working Capital”) or that are held for investment and reasonably expected to be used within two years in connection with research and experimentation or increases in the working capital needs of a qualified trade or business (“Assets Held for Investment”) are treated as used in the active conduct of a qualified trade or business. 
  • However, beginning two years after the corporation was formed, no more than 50 percent of the value of a corporation’s assets may qualify as being used in the active conduct of a trade or business (the “50% Rule”).

Additionally, Investments in Portfolio Securities may cause the company to exceed the “portfolio security limitation”, whereby a corporation shall “be treated as failing [the Active Business Requirements] for any period during which more than 10% of the value of its assets (in excess of liabilities) consists of stock or securities in other corporations which are not subsidiaries of such corporation” (IRC Section 1202(e)(5))

Given the potential impacts cash management can have on QSBS eligibility, there are several key considerations for companies to keep in mind, such as:

1. What holdings constitute “portfolio securities”? 
   • Section 1202(e)(6) defines “portfolio securities” as “stock or securities in other corporations which are not subsidiaries of such corporation”.
   • In general, cash, deposits in checking or savings accounts, certificates of deposit, Treasury bills and other government bonds should not count towards this 10% limitation, nor should certain money market accounts.
   • Money Market accounts may have variations in terms of how the funds are invested.  Ones which hold deposits at banks or other financial institutions and are not used to invest in securities, money market funds or other funds generally should not count towards the portfolio security limitation, however if the money market account invests mutual funds or other corporate securities (in whole or in part), such investments can count towards the portfolio securities limitation (refer to this article from Orrick for further details).
   • As noted by lawfirm, Hanson Bridgett, “Capital held in accounts characterized as ‘mutual funds’ or similar securities should generally be avoided in favor of short-term treasury notes and other highly-liquid investments”
     
2. If investments in portfolio securities were made, are we disqualified from QSBS eligibility? 
   • Keep in mind that the active business requirements need to be met for “substantially all” of a shareholder’s holding period.  Therefore, if the portfolio security limit may have been exceeded, as long as the funds are transferred back to a traditional cash or working capital account in a relatively short period, shareholders should still be able to meet the “substantially all” test for QSBS.
     
3. What is considered “reasonably required” working capital?
   • The Tax Court has defined a corporation’s working capital needs as the amount of cash sufficient to cover the operating costs for a single operating cycle (see Bardahl Manufacturing case).  Therefore , it may be important to know and document your working capital requirements to demonstrate if assets may be considered “reasonably required” working capital.

Please note that this post is not exhaustive of all items to consider. Are there other considerations, best practices and/or questions you are working through? If so, please write us at [email protected]

This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.