How A Little Knowledge of Tax Law Can Accelerate Funding

There are a multitude of factors to take into account when investing into startups: industry, market, size, company stage, and location. Depending on certain factors, an early stage startup may be qualified as a “small business” in the eyes of the IRS. Equity shares of these companies are referred to as Qualifying Small Business Stock (QSBS). The tax benefits for certain investors in QSBS can be magnificent, however special conditions apply. In 1993, in an attempt to stimulate investment into startups and small businesses, the IRS enacted Section 1202 of the Internal Revenue Code to exclude some of the gain realized from the sale of QSBS.

What is QSBS?

QSBS (originating from Section 1202 of the Internal Revenue Code) excludes tax on gains from the sale of stock in qualified small businesses (QSB). A QSB is defined as a business organized as a U.S. C-corporation with less than $50M in gross assets before and after that company receives cash from an equity funding round. Although convertible debt and other promissory notes do not qualify as QSBS, the YC SAFE contains explicit language that qualifies it as an “equity” investment. The company must not be on the list of excluded business types (which includes SaaS businesses).

How does QSBS apply to SPV investments?

All of the SPVs administered by Sydecar are LLCs (pass-through entities). SPV investors qualify for QSBS benefits if they held the interest on the date the SPV acquired the QSB stock and at all times thereafter until the stock was sold.

How do I know if my SPV investment qualifies as QSBS?

Besides the qualifications mentioned above, the SPV qualifies for QSBS only if the SPV acquires original issue shares (i.e. not purchased on the secondary market) and if the stock has been held for at least five years. The company in which you or the SPV invested will know if the shares sold are eligible to be treated as QSBS. Frequently, QSBS is assessed at the time of a 409A valuation. If the stock has been qualified as QSBS, the benefit cannot be taken away until it is sold.

What are the tax benefits of QSBS?

If an SPV (or angel investor) sells shares of QSB after the five-year mark, they may exclude up to 100% of capital gains (depending on the date of purchase) of up to $10M or 10x the cost basis, whichever is greater. It’s important to note that tax laws change frequently so it’s important to check with your tax advisor on the latest developments or changes in the tax code.

What happens if I buy or sell an interest in an SPV that has purchased QSBS?

Since purchasing interest in an SPV does not qualify as selling stock directly, the stock retains its QSBS eligibility within the SPV interest that is purchased. Further, an investor who purchases interest in an SPV (i.e. via a secondary sale) actually inherits the SPV’s holding period. For example, if you purchased interest in an SPV that held QSBS for five years already, that holding period would be applied to your interest (even though you did not own it for the full five years). Conversely, if you sell an interest in a QSBS holding SPV, you are not entitled to exclude any gain on the sale, as you are not actually selling the underlying stock but rather your partnership interest. You as the seller would want to factor the benefits to the buyer into the sales price.

What else should I know?

If the business in which the SPV invested is incorporated in one of the locations below, you won’t be eligible for QSBS exclusion at the state level:

1. California

2. Mississippi

3. Alabama

4. Pennsylvania

5. New Jersey

6. Puerto Rico

Where can I go for more information?

• Section 1202 regulations

• Qualified Small Business Stock definition

• U.S. Small Business Administration QSBS discussion

• This post from Lowenstein Sandler explains the complexity and vagueness of the QSBS laws as it relates to SAFE notes.