Small Business, Big Savings: QSBS Tax Exclusion

Would you like to invest in a small business and cash out your gains, five years later, completely tax-free? It’s possible. Venture capital (VC) fund managers and other investors should look for Qualified Small Business Stock (QSBS), which can qualify for significant tax benefits under Section 1202 of the Internal Revenue Code.

Sec. 1202 was originally enacted in 1993, but the provision has been changed several times, and the Protecting Americans From Tax Hikes Act of 2015  made this exclusion permanent. Right now, any qualifying investment made after September 27, 2010, could be eligible for a 100% gain exclusion.

How does QSBS benefit investment funds?

If a VC fund acquires stock in a C corporation that meets QSBS requirements and holds it for more than five years, some or all of the gain generated from the sale of the stock may be excluded from federal income tax. That can provide a significant benefit for investors.

How significant? If your investment qualifies, you could exclude taxable gains up to the greater of:

• $10 million or
• Ten times your basis in the QSBS

For example, suppose that in September 2019 you invest $4 million in a startup whose stock meets QSBS requirements. If you sell it in October 2024, you could realize up to $40 million of gain from the sale (10x your investment) without recognizing any taxable income, a savings of more than $9.5 million at current tax rates.

How does stock qualify as QSBS?

The QSBS requirements are as narrow as the benefits are broad. Stock purchases must meet all of these limitations:

• C corporation: The issuer must be a domestic C corporation, not an S corporation or limited liability corporation
• Less than $50 million in gross assets: The corporation’s aggregate gross assets must not have exceeded $50 million at any time before (or immediately after) the stock was issued
• Original issue: Stock must be acquired at its original issue, not from a secondary market
• Date acquired: Stock must have been acquired after September 27, 2010, to qualify for the 100% exclusion
• Five-year holding period: The stock must be held for more than five years
• 80% of assets in active trade or business: While you hold the stock, at least 80% of the corporation’s assets must be used in the active conduct of one or more qualified businesses, excluding the following trades or businesses 
  • Professional services — health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services or brokerage services
  • Banking, insurance, financing, leasing, investing and related fields
  • Farming
  • Mining
  • Hospitality (hotel, motel, restaurant, etc.)

Other factors to consider

Partnerships holding QSB stock

Venture capital funds are generally organized as partnerships, and there are some unique rules partnerships should consider when investing in QSBS. In order to qualify for the benefits of QSBS, noncorporate partners must have held their interest in the partnership both when the partnership acquired the QSB stock and when it sold the stock. In other words, it’s not enough for the partnership as an entity to hold the stock for five years; each partner hoping to take advantage of the exclusion must have also held the stock — through the partnership — for the full duration.

Special rules apply to subsequent closings, especially when an LP increases its ownership interest between the acquisition and the selling of the QSBS interest. In such cases, investors can only exclude the amount of QSBS gain proportional to their original investment in the fund. Later, additional investments cannot be added to the basis. 

Convertible debt

A VC fund often makes its initial investment in a company via a convertible note. Generally, the holding period of the convertible debt is tacked on to that of the underlying stock upon conversion. However, to qualify for the QSBS exclusion, the fund must hold the stock itself for five or more years — the holding period for the convertible debt doesn’t count. Determination of whether the issuing corporation meets the asset test is made upon conversion, when the actual stock is issued, and that’s when the five-year QSBS clock starts.

Don’t miss out

The QSBS tax exclusion can be very attractive to VC fund managers and partnership investors. But there are a lot of conditions that must be met and some complex requirements that could cause the IRS to limit or disallow the exclusion. It pays to consult a tax professional who understands both tax law and the specialized environment of investment fund partnerships.

To find out whether — and how — your fund could benefit from QSBS investments, contact Weaver for a consultation.