Qualified Small Business Stock _ Issued by C Corp in US

Internal Revenue Service (“IRS”) provides capital gains exclusion on sale of Qualified Small Business Stock (“QSBS”) that could save personal tax typically for business owners, startup founders, initial employees & angel investors of a startup / small business.

QSBS, are shares of a Qualified Small Business (80% of total assets (must not exceed $50 Mn) of the C Corp are used in active business) which meets specified conditions outlined by IRS. Further, the C Corp issuing QSBS does have restriction while making investments in another corporation and other assets. As per the regulations neither they can invest 10% or more of its net assets in stock of another corporation in which it does not have over 50% ownership nor invest 10% or more of its gross assets in real property not being used in the active conduct of a qualified business. Having C Corp for real estate / passive income investments alongside active business may not enjoy QSBC tax exclusions. In such cases, a different vehicle / entity should be setup for non-business activities and related investments.

Primarily, issue of QSBS has two tax advantages:

1. No Capital Gains on sale of QSBS - Capped at the greater of $10 million or 10x the shareholder’s adjusted basis.
2. Deferral:?At times where an investment in a startup has not gone as per individual’s expectation, IRS Code Section 1045 allows a deferral of the tax. Shareholders can defer capital gains tax on the sale of QSBS if they reinvest the proceeds into another QSBS within 60 days with original holding period is added to the holding period of the new QSBS.

To avail above tax benefits, Shareholder must adhere with following requirements:?

1. Owners / employees must exercise and hold shares and not stock options.?
2. Before the sale, hold QSBS for 5 years. The holding period in the case of SAFE or Convertible Notes begins from date of conversion into shares.

The shareholder must have received shares as part of primary transaction viz issuance by the C Corp and not through secondary transaction viz purchased from another shareholder. However, shares received as a gift or on death will retain QSBS status.

While claiming the tax exclusion, although an individual is not required to submit any documents with their tax return, but it is recommended that following preliminary documents are readily available:

• Article of Incorporation
• Stock Purchase Agreement?
• Tax opinion on QSBS eligibility
• Stock Sale and Purchase Agreement

While holding QSBS, start-up founders and its employees mostly opt for 83(b) election whereby the individual selects to be taxed at the time of grant (day when the value of C Corp would be comparatively lower) which allows holding period for QSBC to start from the grant date and not the vesting date.

By utilizing the tax benefits available on issue of QSBC, business owner and key managerial persons can reduce their personal income tax. However, to optimise personal tax while doing State tax filings, it is important to also evaluate in which State the C Corp should be setup so that QSBS tax exclusions are available at both Federal and State level. For e.g., Alaska, Delaware conforming states with QSBS tax exclusions while California, Pennsylvania are not. Whereas few states like New York, New Jersey have their own set of rules and regulations for QSBS related tax benefits.

It is vital that founders, investors, and employees who wish to utilize QSBS consult professionals for tax planning as well it recommended that every corporation properly documents new shares issued at each round of financing.

Please feel free to consult with our tax professional Urvesh ([email protected]) at Fernandez Young, CPAs and Business Advisors forhelping you on determining QSBS eligibility, personal tax planning and other US tax matters.