Can a SAFE qualify as Qualified Small Business Stock?

Investors seeking to maximize their tax saving are asking whether a Simple Agreement for Future Equity (SAFE) be considered “stock” under Section 1202 of the Internal Revenue Code.

It’s not clear how SAFEs are treated for tax purposes in relation to qualified small business stock (QSBS). In this article, we’ll explain why SAFEs can be tricky when it comes to QSBS treatment, plus what can be done to give stockholders the best chance of qualifying for the tax relief.

What is the QSBS exemption?

The QSBS tax exemption lets investors in eligible small businesses exclude up to 100% of capital gains from federal tax – up to $10 million or ten times their original investment, whichever is higher.

For startup investors and founders, this exemption can mean the difference between a large tax bill and a tax-free gain.

Take a look at our articles on QSBS for investors and QSBS for founders for a deep dive into this topic, which explains it in more detail.

What is a SAFE (and how does it differ from stock)?

SAFEs are a popular choice for investing in early-stage startups. Unlike traditional equity, a SAFE gives investors a right to future stock in the company, usually activated by a triggering event (typically, it’ll be a priced funding round).

But SAFEs don’t have some of the rights that come with equity – they don’t offer ownership, voting rights, or a place on the company’s cap table until a triggering event converts them into stock.

This hybrid nature – being ‘future equity’ without immediate ownership – is why there are questions of whether the IRS might recognize SAFEs as “stock” for the QSBS exemption.

Why does it matter if SAFEs are considered “stock”?

One of the requirements to benefit from the QSBS tax relief is for the investor to have held the stock for five years.

Say we have two investors Alex and Jenny, each investing $100,000 in a startup in 2023. Alex simply buys preferred stock, while Jenny opts for a SAFE that’s expected to convert in a priced round in 2025.

Because Alex received stock at the time of investment, his five-year QSBS clock begins in 2023, and he can claim the QSBS exemption if he sells in 2028 or later.

But Jenny’s five-year clock is less certain. If the Internal Revenue Service (IRS) rules that a SAFE does not constitute stock until conversion, Jenny’s QSBS clock would start in 2025 when conversion takes place. Jenny would only be eligible for the exemption in 2030 or later – extending her holding period by two years compared to Alex.

That’s why it’s important to understand whether SAFEs do constitute “stock” for these purposes – it impacts the timing of the tax benefit they receive.

Why is it uncertain whether SAFEs qualify as QSBS?

The IRS hasn’t clarified whether SAFEs can be considered “stock” for QSBS purposes (they’ve not announced any plans to issue guidance on this either). This leaves SAFEs in a bit of a gray area.

Here are the main arguments for and against their qualification.

Why SAFEs might qualify as QSBS

• How they describe themselves: Modern day SAFEs (like the Y Combinator SAFE) often include terms designating them as “stock” for tax purposes, particularly under Section 1202. Although this intent isn’t binding for the IRS, it supports the argument. But the IRS usually focuses on how a document actually works rather than how it describes itself.

• The rights in SAFEs are like stock: Most SAFEs (again, like the Y Combinator SAFE) come with features that are similar to equity – things like liquidation preferences, dividends, and some tax-related voting rights. These elements make these SAFEs seem closer to stock than debt.
• SAFE-holders’ rights in a liquidation event: SAFE-holders typically have rights similar to preferred stockholders in a liquidation event – this reinforces the view that SAFEs act like equity, not debt.

Why SAFEs might not qualify as QSBS

• Ownership is delayed by conversion: SAFEs don’t provide immediate equity ownership to investors – and without board consent or cap table inclusion, SAFE-holders aren’t entirely treated like stockholders.
• SAFEs could be considered prepaid forward contracts: Some tax experts think SAFEs could be viewed as prepaid forward contracts, not stock. These are financial agreements where one party pays upfront for the future delivery of something at a later date. If the IRS thinks of SAFEs in this way, the five-year QSBS holding period would only start on conversion, when the investor’s stock is actually issued.

As an investor, what should I do?

If you want to ensure your SAFE investors get QSBS relief sooner, here’s a breakdown of options and considerations:

• Request stock over SAFEs: If possible, request stock issuance from the outset instead of a SAFE. This would start the QSBS five-year holding period immediately, making your tax position clear.
• Convert SAFEs to stock early: To reduce uncertainty about whether a SAFE qualifies as “stock” for QSBS purposes, consider converting them into stock as soon as possible. Early conversion will make their tax treatment clear – assume the five-year clock starts from when the SAFE converts. Until the IRS issues a clear ruling, this would be the most conservative approach.
• Speak with a tax advisor: Given the complexities around QSBS and SAFEs, you should speak to a tax professional. They can provide guidance on the nuances of Section 1202 to help you make the most of your investments from a tax perspective.