Top 5 QSBS items in preparation of your financing round

Raising a financing round is a defining moment for any startup. Amidst the pressure to secure funding and finalize term sheets, many founders overlook one of the most valuable long-term tax incentives available: Qualified Small Business Stock (QSBS).

Under Internal Revenue Code (IRC) Section 1202, if a startup qualifies, shareholders – including founders – may be able to exclude up to 100% of capital gains when selling QSBS held for at least five years, translating into $2.38 million in federal tax savings for every $10 million in capital gains, and potentially more at the state level.

This article breaks down five key considerations founders should keep in mind to make QSBS work for their business.

1. Is your company eligible to issue QSBS?

Before issuing stock, founders need to ensure their company meets the basic QSBS eligibility criteria and qualifies. Overlooking eligibility could cost significant tax savings down the road. To qualify there are key requirements.

Company is a US domestic C-corporation

QSBS is only available for C corporations [IRC Section 1202(c)(1)]. Startups structured as LLCs taxed as partnership or S corporations may consider converting, however it is important to consider how best to convert to optimize for QSBS.

Gross assets are under $50 Million

To qualify, the company’s total gross assets must not have exceeded $50 million at all times before and immediately after issuing the new stock (IRC Section 1202(d)). This is not as simple as it sounds, as the asset measurement is on an adjusted tax basis, which can be influenced by factors such as capitalized R&E expenses, the contribution of assets (measured at fair value) and other nuances.

Company operates in a qualified trade or business

The company must be actively engaged in a “qualified trade or business”. The IRS uses an exclusion-based approach to define what trades are and are not considered to be qualified, whereby certain businesses – such as those involved in professional services (law, accounting, consulting), financial services, hospitality, and farming – do not qualify (IRC Section 1202(e)).

Founders should carefully review their business model to ensure it meets the active business requirement, which mandates that at least 80% of the company’s assets be applied towards the qualified trade.

2. What are the QSBS prospects for the new securities?

After confirming company-level eligibility, it’s essential to examine whether the newly issued stock meets QSBS criteria at the security level, or if actions can be taken to help improve the prospects. Overlooking these details can cause unintended disqualification.

Type of security being issued

QSBS eligibility is limited to stock obtained directly from the corporation (i.e. at its “original issue”) in exchange for money, property (excluding stock), or services rendered. Shares issued in a priced round would generally satisfy the original issuance requirement. QSBS is less clear for other security types, however, such as those which may later be converted into stock.

Convertible Notes are generally thought to be “debt like” and therefore not eligible as QSBS until converted to equity.

Treatment of SAFE securities is less clear. While certain attributes can help make SAFEs more “equity like”, and thereby improve the prospects for QSBS eligibility, acceptance by the IRS remains uncertain.

The IRS has historically looked to a security’s attributes for classifying it as debt or equity; as stated in Private Letter Ruling 201636003 “…for federal tax purposes stock ownership is a matter of economic substance, i.e., the right which the owner has in management, profits, and ultimate assets of a corporation.”

Managing the $50 Million Threshold

If the capital raised in the financing round risks pushing the company over the $50 million asset limit, actions may be taken to help retain QSBS eligibility for some or all of the new shares, such as structuring the round into multiple or milestone closings, disposing of assets that are no longer used by the company, or potentially prioritizing investors who can benefit from QSBS (i.e. US individual taxpayers) before investors like corporations or foreign individuals who can not benefit from QSBS.

However such options require careful planning, so it is best to identify the need for such measures well before closing.

Redemption and Secondary Sales Considerations

The company repurchasing stock within one year before and after issuance can disqualify shares from qualifying as QSBS (IRC Section 1202(c)(3)). If stock redemptions or secondary sales are being contemplated in or around the financing, certain actions may help ensure that the transactions are structured in a way that prevents triggering the redemption disqualification.

3. How might existing stakeholders be impacted by the new round?

Cap tables get complicated, and knowing how QSBS applies to the various types of securities the company has issued may be impactful in compensation discussions and in exit planning.

If convertible securities would only first begin their QSBS holding period upon conversion in the new financing round, the securities may only have QSBS potential if the company’s assets are still below the $50M threshold immediately after the round and conversion of the securities.

Stock options generally are not QSBS eligible, however shares acquired through exercising options can be. Distinctions exist for ISOs versus NSOs however, as well as whether the options were exercised early, have fully vested and if an 83b election was filed.

Given the different treatment of various security types, considering the implications prior to a round can help maximize the shareholders whose stock can be considered QSBS.

4. Should planning steps be considered that could help maximize the QSBS benefit?

Careful planning can help optimize which shares receive QSBS treatment. Strategies such as gifting shares to certain types of trusts can multiply the QSBS benefit (i.e. QSBS stacking) or adding to a shareholder’s basis can increase the exclusion limit utilizing the 10x basis exclusion limitation (i.e. QSBS packing).

Financing rounds provide an indication of value for shares, and therefore the opportunity to gift shares may diminish if the value exceeds the gift exclusion limits at the time of the gift. Therefore, it is best to consider any such planning measures as early as possible.

5. What to tell new investors about QSBS eligibility

Stock Purchase Agreements (SPA) often include representations that the shares being issued are intended to qualify as QSBS. Such representations reassure investors and create a record of the company’s QSBS status for certain criteria at the time stock was issued, however these representations do not cover all of the eligibility criteria and can only address what was known at the time of the financing round, not the requirements that need to be met during the shareholder’s holding period.

If such a representation is being made, consideration should first be given to:

1. Ensuring that the stock appears to indeed be QSBS eligible
2. Determining which criteria are and are not being addressed by the representation, and
3. Ensuring that actions such as stock redemptions are not being planned after the financing round that might cause the newly issued shares to lose their QSBS benefits.

Qualifying for QSBS is not a one-time evaluation – companies must continually monitor business activities to ensure ongoing compliance with the active business requirement under Section 1202. Regular reviews of asset usage and balance sheet composition may help avoid unintentionally losing eligibility.

What steps are leading companies taking?

1. Conduct a QSBS review: Engage legal and tax advisors to assess QSBS eligibility before finalizing the financing round.

2. Address potential issues: If risks are identified, act quickly to address the items as soon as possible.

3. Educate key stakeholders: Inform employees, co-founders, and early investors about the benefits of QSBS and how to preserve eligibility.

4. Plan for the future: QSBS is a long-term play. Setting up properly now can lead to massive savings when the company exits.

Financing rounds are often focused on immediate capital needs, but companies who think ahead reap the biggest rewards. By structuring a financing round to optimize for QSBS, founders can unlock significant tax savings at exit – not just for themselves, but for their team and early supporters. Planning for QSBS isn’t just smart – it’s a strategic edge.

About the author

Jonathan Fish founded CapGains and QSBSExpert.com to help founders and investors navigate QSBS and other tax incentives. He is a CPA, and obtained his MBA from NYU Stern and his BS in Accounting and Finance from the Kelley School of Business at Indiana University.