In order to qualify as a “Qualified Small Business”, Section 1202 requires the stock to meet the “Gross Asset” test, whereby the “aggregate gross assets” of the corporation:

1)    Did not exceed $50 million at all times between August 10, 1993 (enactment of the Revenue Reconciliation Act of 1993) and the date of issuance, and

2)    Immediately after the issuance, including the amounts received in the issuance, do not exceed $50 million.

(Section 1202(d))

The QSBS asset test or size test means that the aggregate gross asset value of the business must be below $50 million at all times before and immediately after the issuance of QSBS. If assets are ever over $50 million the business will not at any time qualify for QSBS in the future, but QSBS issued before exceeding the threshold will still qualify.

As shown in the below timeline of when a corporation qualifies as a qualified small business, it is ok for the corporation to exceed $50 million in gross assets during the required 5-year holding period after the QSBS is issued.  However, additional securities issued at a later time would not qualify as QSBS if the Gross Assets exceeded $50mm at any point before issuance of those securities.   

How do you calculate “Aggregate Gross Assets” for QSBS?

Aggregate gross assets include:

  • Cash
  • Aggregate adjusted basis of other property held by the corporation. 

(Section 1202(d)(2))

QSBS considers the tax basis of assets, which are generally reported on Schedule L of a corporation’s tax return (i.e. Form 1120).  The value of assets would include intangible assets such as goodwill.

Basis is generally the amount of a company’s capital investment in property for tax purposes.  Certain events may occur during the period of ownership which may increase or decrease basis, resulting in an “adjusted basis”.  Basis is increased by items such as the cost of improvements that add to the value of the property.  Basis is decreased by items such as depreciation and insurance reimbursements for casualty and theft losses.

The QSBS regulations specify a couple of other common questions regarding “Aggregate Gross Assets”:

  • The adjusted basis of any property contributed to the corporation is determined based on the fair market value at the time of the contribution.
  • All subsidiaries controlled by the corporation (i.e. more than 50% owned) shall be aggregated and treated as one corporation for QSBS purposes.

Do Business Valuations Affect the Asset Test for QSBS Purposes?

Business valuations are conducted on fair market value (FMV) basis, which means “the price at which property would change hands between a willing buyer and a willing seller, neither acting under compulsion to buy or to sell, both being able and willing to trade, both being well-informed about the property and the market for such property, and both having reasonable knowledge of relevant facts (Sections 20.2031-1(b) and 25.2512-1).”

The asset test for section 1202 QSBS is conducted on an ‘aggregate gross assets’ basis, not fair market value.

Startups raising financing rounds based on pre-money and post-money valuations will not affect the asset test for QSBS purposes. Those valuations are based on a FMV that investors are willing to pay for. Startups raising money only take into account what goes on the asset side of the balance sheet (e.g. property or cash).

For example, a startup is raising its Series B financing round at a pre-money valuation of $40 million and intends to raise $15 million for a post-money valuation of $55 million. As long as the company does not have over $35 million in other assets on its balance sheet, the $15 million in cash received from the financing round will not affect the gross asset test for QSBS purposes.

But I’m only a small investor, how do I know if the Company I invested in meets the “Gross Asset” tests?

Many companies are asked to represent that their stock qualifies as QSBS before the stock is issued.  If so, there may be a clause in your “Stock Purchase Agreement” or related purchase documents where the corporation stated that:

 “aggregate gross assets, as defined by Section 1202(d)(2) of the Code, at no time between the date of its incorporation and the Closing, have exceeded U.S. $50 million, taking into account the assets of any corporations required to be aggregated with the Company in accordance with Section 1202(d)(3)of the Code.”

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

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