Posted on November 25, 2015 by Jeanne Goulet
The exemption for Qualified Small Business Stock (QSBS) is an often overlooked, but potentially big tax break for both founders and those investing in small businesses.
Small businesses have been the growth engine of the US economy since the last recession. Congress has helped fuel that engine with provisions in the IRS tax code that can reward people who start and invest in certain types of small businesses.
One of the best breaks available is the qualified small business stock (QSBS) exemption — something savvy angel and venture capital investors in Silicon Valley and beyond are familiar with.
The primary benefit of a QSBS exemption is that you can save taxes when you sell the shares of a QSB, providing that both the investor and the company have met all the requirements for the entire time the shares have been held.
But exactly what sorts of small businesses qualify as a QSBS?
Determining this requires some careful navigation of the IRS section 1202 code, best done with the help of a capable CPA:
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The stock must be that of a Domestic C Corporation (not an S Corporation nor LLC) whose aggregate gross assets do not exceed $50 million.
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The shares of the C corporation that were acquired must have been issued after 8/10/93 when the law was first passed.
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The shares must be held for more than five years.
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The shares must be acquired at its original issue, not from a secondary market (redemptions are limited).
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80% (by value) of the corporate assets must be used in the active conduct of the qualified business.
What types of business qualify? This is best answered by listing what is not eligible. A qualified business can’t be an investment vehicle or inactive business. The following types of businesses do not qualify:
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Performance of services in fields such as health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics or financial services or brokerage services.
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A farming business.
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A business involved in the production of products for which percentage depletion can be claimed.
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A business operating a hotel, motel or restaurant.
All this being said, many early-stage investments in technology companies do in fact meet the requirements for a QSBS.
How much tax can you save?
A lot depends upon when you purchase and when you sell the shares, and whether the alternative minimum tax will apply. The benefits have fluctuated over the years as the tax laws have changed. However, for shares acquired since September 28, 2010 the benefits are the most substantial.
If you can meet all the requirements, then you can exempt from the capital gains tax of 20%, plus 3.8% net investment income tax — up to a limit of the greater of $ 10 million or 10 times your adjusted basis in the stock, whichever is greater.
In recent years Congress wanted to incentivize more investments in qualified small businesses, so it progressively increased the amount of allowable gain exclusion. The 100% exclusion is effective as of
September 28, 2010 and is now permanent. The alternative minimum tax does not apply for the gain that is eligible for the 100% exclusion.
An important safety tip here: Anyone who wants to take advantage of the QSBS tax relief needs accurate documentation that they in fact are entitled to these exemptions. Owners and founders potentially stand to gain the most from QSBS — because they may have a large gain and they were likely early investors.
Another QSBS benefit is the DEFERRAL feature that is available. If you lack the 5-year holding period, and are reinvesting in another QSBS you can roll over the gain into the next qualified investment.
In order to qualify for the rollover deferral into the next investment:
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The QSBS must be held for more than six months.
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The taxpayer must purchase the replacement QSBS within 60 days from the date of the sale.
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The election must be made in the tax return.
In the event you experience QSBS losses (Per IRS section 1244):
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Losses of up to $50-$100K may be deducted as an ordinary loss rather than a capital loss.
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The benefit applies to the first $1 million of capital raised by the company.
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The company must derive more that 50% of its gross receipts from sources other than passive investment income.
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This does not apply to shares received for services rendered.
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Sometimes federal and state tax authorities make it difficult for people to claim tax benefits. Therefore it’s wise to take the following steps
Document your QSBS purchase: Date, amount paid, record of payment and copy of the share certificate.
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Keep track of time: Know the date when you’ve held the shares for five years and one day before your sell.
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If you feel that your shares qualify, get in touch with your QSB and request documentation which proves that your shares in the Corporation have met “all the QSB requirements at all times.” Since this exemption will be part of your individual tax return, it is important for you to be able to substantiate this exemption and have the information available should your tax return be audited.
Because this process and documentation can be quite complicated, your QSB may need to engage a qualified CPA who is familiar with these provisions to prepare the necessary documentation that the investors can use as evidence to support the Qualified Small Business Exemption in their personal tax returns.
This material has been prepared for general informational and educational purposes only and is not intended, and should not be relied upon, as accounting, tax or other professional advice. Please refer to your advisors for specific advice.
Reprinted and used with permission from Marks Paneth LLP
Posted in General Business Matters, US Start-Ups: Overall Tax Considerations Tagged emerging growth companies, Marks Paneth, Tax Benefits for Founders, Tax Benefits for Investors, tax breaks, tax planning
FOCUS YOUR FINANCIAL PICTURE FOR IMPROVED OUTCOMES.
Be sure to focus your financial picture before an audit, exit talks or IPO, because you get one chance to make a great first impression with your financial statements, and you can improve your outcomes as a result.
Tomasz Tunguz – a venture capitalist at Menlo Park, CA based Redpoint Ventures characterized financial statements as “A Rosetta Stone for startups.” He went on to observe in his blog “They reveal the strategies and the tactics of how to bring a product to market.”
Tunguz identified ten key metrics he looks at when sifting through a startup’s operational model, whether he is considering an investment or in a board meeting. They ranged from revenue growth to net income, gross margin to customer acquisition payback period and sales efficiency.
Consider the massive downside financial valuation impact of poorly prepared financial statements, as seen from the Groupon fiasco of April 2012.
Groupon offers deals and coupons for restaurants, retailers and service providers. It made a big splash back in 2011 when its IPO was issued raising $805 million. Investment banks, including Goldman Sachs, made millions in fees.
After an audit revealed “material weaknesses” in its internal controls over financial reporting, specifically in terms of accounting for customer refunds, the company’s stock dropped a precipitous 17% in one day.
The company was then forced to restate its 4th Quarter 2011 financials, and in the end the stock tanked by 44% and $350 million in equity valuation simply vaporized. Groupon’s equity valuation has never fully recovered.
Could this have been avoided? Certainly yes, had these problems been rectified prior to the financial audit by engaging in thorough pre-audit preparation.
Here are some key areas to examine in terms of your company’s financial statements, in order to maximize your selling price and to minimize potential hold-backs.
Hold-backs occur when there are issues with your business that potentially have not been properly managed. As a result the buyer may be interested in setting aside money in the event that these risks materialize, and result in tax liabilities and penalties that will potentially need to be paid out.
These business issues of concern to a potential buyer usually come out during the due diligence process. They can include: failure to file federal, state, local and foreign tax returns – with potential taxes being owed; failure to collect and remit sales tax; and improper characterization of independent contractors. These are are all common triggers for hold-backs.
It is extremely important to work with a qualified CPA to rectify these potential problems prior to exploring exit options, so the issues can be corrected and the valuation of the company can then be optimized.
Another important task is to evaluate your company’s valuation under alternative structures and then prepare a negotiation position.
For example, explore the potential consequences of selling assets vs. stock. Buyers often prefer to buy assets over stock because it allows them to avoid taking on liabilities and business issues or risks facing your company. And buyers can then step up the valuation basis of the assets and then depreciate from a higher level, usually reducing their tax liability in the process.
As the seller, you may face a high tax rate (65% rate) that you can perhaps negotiate and have the buyer pay part of the tax bill. If the buyer is willing to buy the stock and then can’t get the lower tax rate, they may in turn offer you a lower price. There are also tax-deferral strategies, including installment sales and earn-outs.
So it pays to take all these variables into consideration, and develop an exit strategy that will work best for you.
You will also need to identify the information requirements for potential buyers and their respective due diligence process, as different buyers will likely have different requirements. Consider the view of Venture Capital or Private Equity firms who want a company that can stand alone, versus a strategic buyer who plans to integrate your business into their existing business structure.
It’s important to have all the relevant information a buyer may need readily available in advance, because good first impressions are important to help foster the best exit negotiation outcomes.
“Be prepared to discuss detailed and pointed questions about company information, strategy, growth plans and operations, as the buyer will pick through your balance sheet and income statement” as Tomasz Tunguz points out.
Identify and highlight major deal issues from an accounting and financial perspective, and either remedy or prepare a response for the issues for the buyer’s due diligence inquiry. Examples include revenue recognition methodology, aging of accounts receivable, unfavorable contract terms with significant customers or system limitations. Develop potential solutions that will help minimize the impact of these issues on your exit negotiations.
On the positive side, be sure to identify and highlight potential upside indicators for the business that can enhance the value. If you have expansion plans, or the buyer has a particularly good fit with your business model that will enhance the growth trajectory of both companies – this is the time to bring it up.
Also consider impediments that might slow down the deal – for example if you need to transfer key contracts to the new owner you may need customer approval to do so. Transfer of outstanding loan liabilities may require the lender’s approval as well. You may even need to deal with structural issues for the company that will help facilitate the sale. Any number of these issues can and will have an impact on the final valuation of the company.
If you are selling at a multiple of earnings, say for example 10X, any significant reduction in the company valuation can have a big material impact on the final sale price of the company.
In other words, any problems with your financial statements can cost you plenty in the end!
This material has been prepared for general informational and educational purposes only and is not intended, and should not be relied upon, as accounting, tax or other professional advice. Please refer to your advisors for specific advice.
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