QSBS Qualification

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QSBS can result in $2.38M saved for every $10M in capital gains. There are various requirements for an entity to qualify, including:

(1) Entity needs to be a C-Corp or taxed as a C-Corp
(2) Certain trades and business do not qualify (especially entities where the ‘principal asset is the reputation or skill of one or more of its employees’.
(3) Gross Assets were less than $50 million when the shares were issued.
(4) The company demonstrates that it applied substantially all of its assets towards the qualified trade or business.
(5) Certain corporate actions such as share repurchases can some or all of the entity’s shares from qualifying as QSBS.

QSBS Qualifying Criteria: Entity Type

TIP

❖ To be considered a Qualified Small Business, the company must be a domestic C-Corporation or a domestic entity taxed as a C-Corporation. .

❖ If an entity starts as an entity other than a domestic C-Corporation and later converts to a C-corporation, the 5-year holding period would generally not start until the C-corp securities are issued.

❖ If the entity converted to a C-Corp, there could be a step-up in tax basis of securities at the time of conversion, which could ultimately increase the eligible exemption amount (i.e. $10M or 10x each taxpayer’s basis).

IRC Section 1202(c)(1)

QSBS Qualifying Criteria: Qualified Trade or Business

TIP

❖ The intent of Section 1202 and the QSBS tax exemption is to incentivize investment in entrepreneurship and innovative companies in order to drive future economic growth. In order to be considered a Qualified Small Business (QSB), the Company must be active in a qualified trade.

❖ In general, QSBs are scalable type businesses that have the potential to spur economic growth. IRC Section 1202(e)(3) defines qualifying businesses in the negative, excluding certain industries and companies where “the principal asset of the business is the reputation or skill of one or more of its employees”.

IRC Section 1202(e)(3)

QSBS Qualifying Criteria: Size

TIP

❖ The QSBS guidelines define “small” companies as those with gross asset levels below $50 million.

❖ Stock issued after a company has exceeded $50 million in aggregate gross assets will not qualify as QSBS. Stock issued before that threshold was surpassed is eligible for qualifying as QSBS, and will continue to qualify after the company exceeds the $50 million threshold.

❖ Aggregate Gross Assets include cash and aggregate adjusted basis of other property held by the corporation; it does not consider the valuation of the company. This data is best evidenced through the tax return balance sheets and details of fundraising rounds.

IRC Section 1202(d)

QSBS Qualifying Criteria: Use of Assets

TIP

❖ The QSBS requirements not only look at the quantity of assets the company has, but also seeks to ensure that the company is applying “substantially all” of its assets towards the qualified trade or business.

❖ IRS guidance on exactly how elements of the Active Business Requirement are satisfied is limited, however the code states:
➝ At least 80 percent (by value) of the assets of the corporation are used in the active conduct of one or more qualified trades or businesses during substantially all of the taxpayer’s holding period for such stock.
➝ No more than 10% by value (in excess of liabilities) of the corporation’s assets consisted of stock or securities in corporations which are not subsidiaries.
➝ No more than 10% by value of the corporation’s assets consisted of real estate not used in the active conduct of a trade or business.
➝ Working capital must be at “reasonable” levels and any assets held for investment to finance R&D must be less than 50% of the Company’s total assets after the first 2 years of the corporation’s existence.

IRC Section 1202(e)

QSBS Potentially Disqualifying Criteria: Stock Redemptions

TIP

❖ The previous sections each dealt with the “qualifying” criteria, however there are also several actions that can “disqualify” stock from being QSBS eligible.

❖ The main disqualifying criteria involves ”stock redemptions,” whereby the company repurchases a portion of its securities. While certain types of redemptions are permitted per IRC Section 1202(c)(3) (i.e. redemptions due to terminations, death, divorce, etc.), other redemptions, if considered material, can negate the QSBS status of portions or potentially all of the company’s shares.

Section 1202-2

TIP

❖ To claim a QSBS exemption, as per IRC Section 1202(b)(2), qualifying stock needs to have been held for at least 5 years.

❖ The starting date of the 5-year holding period varies based on security type. For example, the “QSBS clock” for convertible notes does not start until the notes convert to equity and the clock will not start on stock options until the options are exercised.

❖ Stock held for less than 5-years may be eligible (as per IRC Section 1045) to be rolled over into other QSBS whereby the holding period tacks to the previously held stock.

Section 1202(c)(1)

The following summarizes a “high-level” overview of the company’s Qualified Small Business eligibility based on the information you provided.

Entity Type

Qualified Trade or Business

Gross Assets

Use of Assets

Stock Redemptions

A deeper analysis of the company can help determine the likelihood of whether or not the company fits the criteria of being a Qualified Small Business. For a deeper analysis of your company, please hit “submit” below and a member of our team will be in touch.