Many actions or decisions companies routinely make can jeopardize qualified small business stock (QSBS) status.
Suppose after starting your company and qualifying for all of the criteria for QSBS, you meet Charlie, who you’re convinced can help take the business to the next level. Sure, you may wish that you met him at the start, but life just doesn’t work that way.
You join forces and to welcome Charlie to the team you offer him founder’s equity. Two years later, after many long nights your business is booming and you receive offers to be acquired. The team gathers to celebrate and calculates their returns, assuming no capital gain taxes will need to be paid, after all the Company was founded more than 5 years ago and met all of the QSBS criteria.
Also at the celebration is your personal tax accountant, who takes you aside and says “didn’t you redeem stock when you admitted Charlie a couple of years ago? Hate to burst your bubbly, but that redemption may have restarted the QSBS clock.”
Turns out your accountant was right, but why?
Consulting the Code
For a stock to be unarguably considered newly issued, the QSBS corporation cannot make any stock redemptions/purchases from the investor or anyone related to the investor, under the meaning of section 267(b) or 707(b), within a four year period starting two years before the issuance of the QSBS and two years after the issuance.
The original purpose / intent of QSBS is to help fund Qualified Small Businesses in order to spur economic growth. Therefore, QSBS is focused on cash going into QSBS businesses to help them grow.
A stock redemption is when a corporation repurchases its shares from its shareholders for cash or property. There are two results when a corporation repurchases its shares, which are to either (i) retire the shares or (ii) hold the shares as treasury stock.
Stock redemptions involve taking money out of the business for the company to repurchase its own stock. Section 1202(c)(3) and Section 1202-2 specify that certain purchases by the corporation of its own stock (i.e. redemptions) will cause the stock to no longer be considered QSBS, including:
- If the corporation purchased any of its stock from the taxpayer (or related person) during the 4-year period beginning on the date 2 years before the issuance of the stock. (i.e. $10,000 oe 2% of the value of the taxpayers stock at the time of the transaction)
- If the corporation made “significant” redemptions, defined as redemptions of more than 5% of its stock, during the 2-year period beginning on the date 1 year before the issuance of the stock.
A Few Exceptions
Although the corporation’s stock is non-qualifying after one or both of the above events occur, there are a few scenarios where the corporation can repurchase shares without the transaction affecting the Section 1202 qualifications. According to Section 1202 the below are exceptions to the above rules:
- Termination of services (Employee’s or directors)
- Disability or mental incompetency
The termination of services could mean that a founder or employee has (i) been fired, (ii) retired, or (iii) other bona fide termination of services. Generally, death, disability, or mental incompetency would fall within the termination of services as well. In the state of a divorce, an employee or director could be ruled by court to split its stock between spouses; therefore, the corporation may repurchase the spouse’s stock.
Protecting QSBS Status
In order to help ensure QSBS status is retained, investors may require the corporation to make certain representations and warranties. These could include that the corporation will not take actions such as redemptions which could disqualify the favorable tax treatment afforded to QSBS, for example:
Qualified Small Business Stock. The Company will use commercially reasonable efforts to cause the Preferred Stock to qualify as “Qualified Small Business Stock” under Section 1202 of the Internal Revenue Code of 1986, as amended. The Company will use commercially reasonable efforts to comply with the reporting and record keeping requirements of Section 1202 of the Internal Revenue Code of 1986, as amended, any regulations promulgated thereunder and any similar state laws and regulations and to not repurchase any stock of the Company if such repurchase would cause such shares not to so qualify as “Qualified Small Business Stock.”
This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.