Qualifying QSBS investments are not hard to find but they can be hard to maintain. A few key caveats to consider when navigating your investment tax planning for follow on investments is (i) the QSBS asset test, (ii) the timeline, and (iii) the tax exclusion. The QSBS asset test is a guideline that requires companies issuing QSBS to maintain aggregate gross assets under $50 million at all times before and immediately after the investment. Therefore it is important to have a letter from the company stating that it qualifies as a qualifying small business for Section 1202 QSBS. Generally speaking, there is no cap on the dollar amount that can be invested whether it is one lump sum or multiple investments over time unless the investment pushes aggregate gross assets over $50 million.
If an investor is weighing the pros and cons of making a follow on investment and one of the make or break points is that the investment qualifies for QSBS it is imperative to be cognitive as to whether the company maintains under $50 million in assets with the investment. Although this is true for the follow on investment, if the company goes over $50 million in aggregate gross assets it will not affect the prior investment.
The second caveat to keep in mind is the timeline. If there is a follow on investment made it does not piggy back onto the prior investments timeline. The follow on investment will need to be held for at least five years on the date it was issued.
The third caveat to make note of is the tax exclusion you will receive. If the current investment is $1 million or less the maximum tax exclusion you can take is $10 million, but if you make a follow on investment your tax exclusion can expand. Under Section 1202 the tax exclusion is $10 million or 10x the initial investment; therefore if the investment was increased from $1 million to $2 million the tax exclusion would increase from $10 million to $20 million ($2 million x 10).
In conclusion, it can be beneficial when investment tax planning to look at the tax effects of Section 1202 QSBS and follow on rounds. There could be benefits to making a second investment. For example if you believe your current investment will exceed the $10 million tax exclusion cap it might be worth while to make a follow on investment and hold the stock for a little longer.