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Managing Taxes

QSBS Bootcamp for Founders, Investors, and Employees of Early-Stage Companies

Key takeaways

  • Required documentation for the five-year holding period

  • The implications of transferring or gifting shares  

  • Actions that may disqualify you from receiving QSBS exemptions 

  • Why the definition of “working capital” is critical to receive QSBS benefits amidst today’s market turbulence 

Ann Lucchesi: Welcome, everyone. We are so happy you're here for the Qualified Small Business Stock Bootcamp. We've had an overwhelming response to this webinar, including 150 questions submitted in advance. So, we're going to get started because we've got a lot to cover today. I'd like to start by introducing our speakers, starting with my colleague, Danielle Green, a managing director and fiduciary advisor here at SVB Private. She works with clients to navigate their business and personal wealth goals and identify strategies to help them meet those goals efficiently.

Secondly, I'd like to turn to Christopher Karachale, a partner at Hanson Bridgett. He advises individuals and businesses on a range of tax planning issues. He is a nationally recognized expert on qualified small business stock and related Section 1202 issues, and he's one of my go-to’s on this subject. Finally, myself, Ann Lucchesi. I act as a liaison between the commercial bank and private bank here at SVB. I'm a certified financial planner and a certified equity professional, and I spend a lot of time advising founders and executives of private companies on how to plan across their entire balance sheet.

All right. I think we're going to get started with a poll question. So, a pretty basic question, is the exclusion underneath QSBS the greater or the lesser of $10 million or 10 times the adjusted cost basis? This question's going to pop up on your screen. Please select greater or lesser. And while you're answering that, I'm going to cover the topics we're to go over today. So, we have a broad range of people on this call. We're going to start with some of the very basics of QSBS and the tax benefits thereof. We're going to go over some of the requirements for eligibility. And then we're going to do a deep dive into kind of the working capital exception and how recent market trends are affecting QSBS.

We're going to end up with something a lot of you had questions about, which is, how do I extend this exemption through transfer planning? And then finally, what are some of the nuances around M&A? Then we're going to hopefully have a little time to cover some of the Q&As from your founder, investor, and employee peers. We've woven a number of the answers to the questions we received in advance throughout the presentation. If you have questions today, please submit them via the Q&A section and include your email so that we can follow up afterwards if we don't get to them during the session. This presentation is for educational purposes only, it is not a tax advice session. So, we encourage everybody whose situation is unique to consult their own tax counsel.

Let's take a look at the poll results and see what we have. All right. It looks like it's about half and half. About 46% believe that it's the greater, and 54% think the lesser. The answer is it is the greater of the two. And why is this so special? Because very rarely within the tax code do we find a place where the government's going to let us exclude the greater of the two, and it can have a great impact on your wallet. So, from here, let's get right into why QSBS is important. Why is it important? It's important because you may end up paying no federal tax on the first $10 million in gains at the time of a liquidity event or 10 times the adjusted cost basis, whichever is greater. But the acquisition date matters.

So, this rule has been around since 1993. It's just that it didn't have a lot of impact back then because it was a 50% exclusion and all of that gain was still pulled back into AMT or the alternative minimum tax code. It became much more effective in 2009 where it was moved to a 75% exemption. And these are, by the way, dates that apply to issuance of the shares, just to be clear. In September of 2010, it was moved to 100% exclusion, which is pretty impactful. For purposes of the webinar today, we're going to spend a lot of time talking about the 100% exclusion, but do know that you may qualify for one of these other dates. All of this has been focused on federal taxes, but state taxes matter as well.

Now, interestingly enough, about 42 states out there are what we call conforming states, which means they conform to the federal code around Section 1202, and you also would not pay any taxes in those states. Within the other states, there's a variety of things. Some have their own code around Section 1202 and some disregard it completely and just call it income that's going to get taxed, such as in California. So, in California, you're taxed on the whole amount regardless. That was a shift in law. Several states have been changing their laws, so just pay attention to make sure you get advice around that.

And then finally, you might be able to extend this and get more than the $10 million through proper planning. Danielle's going to cover that a little later in our session. So, what does it really mean to you? What do the numbers really mean? Well, let's assume that a founder has a liquidity event where they take $5 million in gains. If those shares qualify for long-term capital gains treatment at the time of sale, but are not QSBS qualified, they would end up paying about 23.8% to the federal government. It's 20% for long-term capital gains tax and another 3.8% for the net investment income tax, for about $1.19 million. That's the check that would be going to the federal government.

If on the other hand, those shares actually qualified for QSBS treatment and were purchased after September 27th, 2010, there would be no federal tax due. So you would basically keep $1.19 million in your pocketbook. Again, state taxes are applicable and I'm going to pause right here because we had questions around international taxpayers. And I want to clarify, this is absolutely geared towards U.S. taxpayers and the U.S. tax code. If you have international taxpayer paying to be done, you're going to have to consult with your accountant around how that might be affected.

Let's jump into some of the eligibility requirements. And I want to say upfront, just so you know, that there's a lot of nuances and a lot of special things in this code. We're going to do some broad brush strokes to understand what some of the basic pieces of qualification are. So, first and foremost is that the issuing company has to be a domestic C corporation at the time of issuance and at the time of sale. And for those of you that understand the way the law works, a C corporation that has elected an S corp for tax purposes, that disqualifies them from QSBS. However, if you start as an LLC and you properly flip into a C corp, you may be able to go ahead and take that election on the C corp shares.

The second test is going to be gross assets of the company at the time that the shares are issued. So, the gross assets have to be at $50 million or less immediately before or after the issuance of those shares. So, one of the things that has come up and asked about a lot is, "Hey, you know, I'm an early employee at a company and I got options, so the company wasn't worth $50 million, they were a C-corp issuer. Do I qualify with my options?" And the answer is, no, options do not qualify. You actually have to take the step of exercising those options, getting the shares in hand , and that would be the date of issuance under QSBS. So, the point in time when you exercise, you still have to meet these qualifications in order to have the clock start to tick.

So, the next question might be, Well, if I exercise options early," and early exercise are generally options that have not yet vested that are going to vest downstream. And when someone does that, we typically would encourage them to take an 83(b) election, which we're not going to go in-depth about today, but just suffice to say it changes the tax quality on those shares. If you take an 83(b) election and you still meet these metrics, those shares would qualify for QSBS. If on the other hand you do not take the 83(b) election, what will happen is that each vesting point in the future, you have an individual taxable event and a new kind of tax basis on that portion of the shares. And so some may end up qualifying and some may not qualify, it just depends on when the vesting schedule looks.

Let's move into the next kind of three pieces we're going to talk about on eligibility. First and foremost, you have to get it directly from the issuer. You get a lot of questions around, "Hey, I bought stock through a secondary. Do those qualify?" The answer's no. It has to come directly from the issuer in exchange for cash, property, or sweat equity. So, sweat equity might be a founder starting it, but not for stock. So, pretty important. The shareholder has to be of a particular...like an individual trust, state, partnerships. So, flow-through entities cannot be a C corp. And finally, and this one's important, the shareholder has to hold the stock continuously for more than five years to qualify.

That's high level, the basic qualifications. There's a lot of other nuances, and one of those that I want to touch on are some of the risks to disqualification even if you meet those metrics. The biggest one around that is what we call redemption of shares. And we think about the redemption in two ways. First is redemption of your shares or people that are related to you, and redemption as a whole by the company. So, for you as an individual, if you have had shares redeemed that there's more than two percent in a period two years before or two years after issuance of the shares, they would not qualify, even if they meet the other metrics.

And then the second one, which is kind of a more important one is, if the issuer does a redemption of more than five percent in aggregate, then it goes a look-back of a year and a look forward. And all shares issued during that two-year period of a year before to a year after would be disqualified under QSBS. So, we really encourage people to be thoughtful about that as they're managing their company and thinking about doing any sort of redemption. All right. I think it's time for our next poll question. True or false, once you have met the five-year holding period, you no longer need to worry about the company continuing to meet the active business requirements. The question's going to pop up. Select either true or false. And while we're waiting for those responses to come in, I'm going to talk a little bit about what Christopher's going to cover in the next section.

So, the first place he's going to start is a conversation about which companies actually are eligible for this, for QSBS, and he'll go into depth around that because there's a lot of nuance in this. And then secondly, he's going to talk about working capital, holding cash if you're a company, how you think about investments. And he is going to do a deep dive there. This is a subject that's near and dear to our hearts because there was a lot of commotion in the marketplace this year and people being very thoughtful about how their cash is managed as a company.

I think the responses are in. So, let's take a look at what the results look like. So, it looks like the answer is true for about 22% of you and 78% think that it is false. The answer is it matters over your entire... Essentially, the way the law reads is, the active business requirement is covered during, essentially, the entire time of your holding. So, if you hold stock for eight years during substantially all of that time, companies must meet that active business requirement. It's one of the reasons we encourage people to really think about the fact that the longer you hold those qualified shares, the higher the chances that something might happen that would disqualify them. So, keep that in mind as you go through this. All right. I'm going to hand this over to Christopher to take it away.

Christopher Karachale: Thanks very much, Ann. Well, it's a real pleasure to be here. I love talking about QSBS. And what's important to realize for listeners is there's a lot of unanswered questions. We don't know a lot of the answers, in part because QSBS, well, Ann said, it's been around since 1993. It's only since 2015 that the 100% exclusion has been in place. And so, what it means is, you know, we're only really 8 years into people taking advantage of this and really trying to optimize for the 100% exclusion, the $10 million or 10 times your basic exclusion. So, there are a lot of unanswered questions, but I think, you know, increasingly, the IRS has issued guidance, and we're starting to get a more sort of concrete understanding of what qualifies and what doesn't.

So, I'm going to talk about a couple of things here. You know, in order to get QSBS, Ann spoke a lot about from the shareholder perspective. About getting the shares at an original issuance from a C corporation, not having the redemptions. So, you know, there's shareholder requirements, but there's also requirements for the company, C corporation, these things. 1202(e) talks about qualified trades or businesses. And 1202(e) contains a variety of requirements. And I kind of look at them as, they're sort of subjective requirements, which we're going to talk about, and then objective requirements. The subjective requirements we'll talk about on this slide.

So, 1202(e)(3) says, a qualified trade or business, that's a company that can issue QSBS, is any company other than a company engaged in certain trades or businesses and they're listed here, professional services, banking, financing, and then it goes on to say, "Or any other trade or business where the principal asset of business is the skill or reputation of one or more of the employees." That's what it says. I can see 727 people on this call. I'll bet 724 of them are in the fintech space or these sort of places. And so, you know, the question really is for people in the fintech space or the insuretech space or the medtech space, or, you know, a lot of the people that here in the Bay Area in the startup world, what does this mean?

The IRS since 2014 has issued seven pieces of administrative guidance. There are private letter rulings, there are actually six private letter rulings, and then a chief counsel advice. These are pieces of guidance that kind of outline the IRS's position. In six of the seven, the IRS had said, "Even though the company is engaged in one of these listed fields, it's still a qualified trade or business." So, five of the private letter rulings involve companies in the health field, two involve companies sort of in the brokerage service, insurance space. But as I say, the IRS said in six of the seven, it's still a qualified trade or business, even though it's engaged in one of these listed categories.

And what the IRS, if you read all of this, what the IRS is really looking for is to say, "Look, we're not going to give QSBS to service industries." For example, I don't get QSBS because all I do is deliver legal services. And Ann doesn't get QSBS because all she does is deliver financial services. But if I build, you know...oh, you can't see my phone. If I build on my phone an app that designs an algorithm to help founders figure out if it's QSBS, that can be a qualified trade or business because I'm not delivering legal services, I'm building something that provides a way for people to come to a solution, even if it is in the service industry.

There's a pharmaceutical company described in this 2014 private letter ruling. And it says, "The company used its manufactured assets and IP to add value to its customer's lives." That same language is repeated in a private letter ruling issued in 2021 involving a medtech company. But the key here is, it says, "If you're using manufactured assets and IP to add value to your customer's lives, in other words, if you're building something, that qualifies, even if it is in one of those listed fields." This is a confusing category, but I guess as long as you remember, if it's not just purely services, and this is true of like SaaS or any of these other areas right on the line, as long as you're building technology, and that technology, even if it delivers services in one of consistent fields, you're probably still okay.

So, as I said, the first slide where we talk about 1202(e)(3) is really more a subjective test. Are you in one of those categories or not? This slide deals with the more objective tests. 1202(e) says, you know, and mentioned this earlier, "For substantially all the taxpayers holding period, 80% of the assets have to be used in a qualified trade or business." So, you know, they've have to be used in one of those businesses that we talked about in the prior slide, but the company also has to meet a few other requirements. One of these is that no more than 10% of value of the assets can be investments. And so, if you get a big funding round, you can't go out and buy a bunch of Apple stock.

Again, from a policy standpoint, it makes sense because what the statute is designed to do is say, "If you get a big funding round from the VCs, you have to use that to go hire more engineers or build more product." They don't want companies to be investment companies. Another important category is you can't have more than 10% by value holding real estate. Sometimes people are trying to shoot on QSBS into a company that is really principally a real estate company, that doesn't qualify either. And then one last point here before we'll go on to the kind of working capital question. Remember that it says for 80% of the taxpayers holding period. For substantially all the taxpayers holding period, 80% of the assets have to be used in a qualified trading business.

So, this is a super important test because you've have to look at this and cover this a little bit, I want to really emphasize it. QSBS has to be applied on an individual-by-individual level. People call me up all the time and say, "Hey, is my company QSBS?" And I say, "You frame the issue entirely wrong. What you really need to do is think when did you get the shares, and for your holding period, does the company meet their requirement?" And so for example, Ann and I can both be investors in the company. I'm the founder and she comes in as employee number 10, and waits to exercise her options or whatever else. We're both invested in that same company, but my shares qualify, but hers don't. So, as I said, that's the important question there on the 80%.

Let me step back. So, 1202(e)(6) says that for the first 2 years the company's in business, all your working capital counts toward being used in that qualified trade or business. If you have just a bunch of cash in the company...and we'll come back to what working capital means, but you just have cash in your bank account, all that counts towards being a qualified trade or business under the general 1202(e) framework. But 1202(e)(6) says that after 2 years, no more than 50% of the total value of the company can be cash. And what this means, really, and this is when people talk about the 80% active business test, this is what they're really talking about, this final box here on the right.

So, it says that after 2 years, you have a 2-year safe harbor, and then after 2 years, no more than 50% of the value of the company can be cash. The other half of the value of the company needs to be something that you've built. So, for example, when we're examining whether a company is a qualified trade or business, I say, "Send me your 409(a)'s and send me your term sheets from the VCs. Because those term sheets from the venture capitalists are going to say, "We'll invest $5 million on a $30 million pre-money value." That data point helps me show that someone believes $30 million of value exists in that company.

And let's say the company has $2 million of cash before the funding round. The VCs are saying there's a $30 million value. That means there must be about $28 million of IP or goodwill or something that's been created in that company. That is what this 50% test is really looking at, to show that the company has created something, an asset. And if you think about where we started with the 1202(e)(3), you can't be in those service industry categories as a sort of subjective test. This is kind of the objective equivalent. In other words, this test is trying to check, are you just making cash coming in and going out to pay vendors, or are you building something? Have you created IP or goodwill or widgets or whatever it is? So, that's, again, at 30,000 feet what this 1202(e)(6) test is about.

In terms of the goodwill... So, again, for the first two years, the working capital. For the first two years, all that working capital counts, and you can use that. After two years, you have to show that you've built something. But this question, and Ann mentioned this before, so what is working capital? The IRS has given no guidance on what working capital means for purposes of QSBS, but there's a lot of other guidance out there that makes clear that it's money that you need to keep in your bank account to deploy to pay your expenses, your employees, you know, a potential acquisition, whatever it is. I think the way to look at it though, because of the lack of guidance is really about documentation. That when we're talking with clients, the number one requirement is to say, "Hey, look, map out what you're going to need to use that money for. And whether it's a board resolution or something with your accountants, spend time documenting how you're going to spend the money." So, that's just ordinary working capital.

Now, there is a provision in (e)(6) that says you can hold investments if it's going to generate investment income you could use for more working capital. There's a tension here because remember, no more than 10% of the value of the company can be investments. And so, you have this restriction on investments versus on working capital. And our position, which I think is based on sort of analogous guidance from the IRS, is to say, "Look, as long it's short-term investment like treasuries or whatever else, as long as it's liquid or cash sweeps or anything else, as long as the money can go in and come out, that's working capital. But just be careful if that working capital starts to look more like investments."

In fact, somebody asked a question that I have, you know, trading or holding crypto. Is trading or holding crypto working capital? I don't think so. Because if you hold a lot of crypto, it starts to look like you're an investment company. First, you could go over that 10% investment threshold. But more importantly, I think the key is to think that working capital bucket really needs to be money that you can immediately deploy if you have to go out and hire a bunch more engineers, or, you know, you've decided, "Hey, we've have to go and acquire this competitor, and we need that money ready to go and be able to deploy it."

And again, I appreciate that you can own Apple shares and you can buy and sell it immediately, but it starts to look like an investment if you're holding a bunch of stock or crypto or something else. So, think about having liquid cash or investments. And then more importantly, I think we'll come back to this at the end, document your needs. For the 6 months, for a year, or for 18 months, what are you going to need to use that money for? 

Ann Lucchesi: Thanks, Christopher. I appreciate it. I think what we're going to do is move into our third and final poll question, which is, if you convert your LLC to a C corp before the growth assets exceed $50 million, does the acquisition date tack back to the date that the shares were acquired from the LLC? So, this is a yes or no. While you guys are answering that, I'm going to cover a little bit about what Danielle will be covering in her section. So, first and foremost, we had a lot of questions around this, which is $10 million's, great, but is there a way to kind of extend this out through gifting, through transfer? She's going to delve into that and talk about what you can and can't do within that realm. And then second, she's going to talk about, well, what happens if I get acquired before I hit my five-year mark?

What are the options? What are things I can do? How do I need to think about that? So, let's see what the results have said on this. What do you guys think? So, it's pretty closely split 43% to 57%. And I know that if Christopher were answering this, he will tell you there's some nuance here. I'm going to tell you generally the way this is viewed is your C corp is going to be the date that you're going to look at for the five-year start date. So, if you think that you've owned the shares for capital gains purposes, it may be a different date and point in time as your start date than it would be necessarily for the QSBS. So, you have to think about these a little bit, get some tax advice around it. From here I'm going to turn it over to Danielle. Take it away.

Danielle Greene: Thanks, Ann. Well, stacking is a great way to further increase the tax savings in the QSBS phase. And as Ann mentioned earlier, the potential tax savings is that a taxpayer may pay no federal tax on the greater of $10 million in gains and 10 times the adjusted cost basis. Now, for many taxpayers, $10 million is more than sufficient to offset gains. But what happens if your gain is more than $10 million? I mean, that's a great problem to have. And with some advanced planning, you can extend the QSBS election, and it's by stacking them, is what it's called.

So, under 1202, the exemption is per taxpayer. So, the strategy is to use or to create additional taxpayers to transfer eligible QSBS stock to...each transferee also gets an exemption. This must be done in a non-taxable transfer. So, think of transfers by gift or at death. If stock is acquired through a taxable transaction, such as a secondary, it does not qualify. So, how do you employ stacking? One example is transfers to individuals. So, your stockholder, you have two siblings and you transfer stock to both of them. So, the original stockholder and each sibling are separate taxpayers, so there's three taxpayers there.

The exemption can be up to $30 million, $10 million for the original stockholder, 10 for each sibling. Now, one important item to note is that spouses may be treated differently under the code. There is a legal disagreement whether the IRS allows each spouse's separate $10 million exemption there, and we can dive into that a little later. I'm sure Christopher has a lot to talk to you there. Another method to employ the stacking would be transfers to non-grantor trusts. So, you are a taxpayer, you have three children, you work with an attorney and create three non-grantor trusts, one for each child. So, including the original stockholder, there are four taxpayers, exemption can be up to $40 million.

Now, partnership interests can also be gifted and retain the underlying quality of the shares. Now, important planning tips here that you should keep in mind is that the QSBS shares should be gifted when the values of the shares are as low as possible and well before the company is sold. The recipient has the same cost basis and holding period as the transferor. And these are both good things. One is if you're going with 10 times basis, at least you have that from the transferor, and with the 5-year requirement at least you're tacking on and the transfer date doesn't start at year 0. So, those are both positive things.

Other items to keep in mind is that completed gifts of QSBS are subject to gift tax rules and reporting requirements and you should always consider state tax ramifications as Ann, and I believe Christopher, both mentioned that not all states follow the federal treatment of QSBS. A lot of questions came in about the gifting shares and how to value them for gift tax purposes. You need a qualified appraisal that meets all of the adequate disclosure rules under the Internal Revenue Code and treasury regulations. Often we're asked if the 409A valuations can be used, and the answer is usually no. It's not acceptable. They don't meet the adequate disclosure rules. Ultimately, it's up to your tax advisor, but there may be an audit risk if you do go with a 409 valuation.

So, what happens when the company is acquired before the shares hit the five-year holding period? So, non-taxable transactions, I'm going to put them in three buckets. The first one is that your QSBS stock is acquired in a stock transaction by a company whose stock is a QSBS-qualified company. The stock you receive maintains the same holding period and the same QSBS treatment. And you can also accumulate more QSBS tax gains to be included in the exclusion when you ultimately sell the second QSBS.

Another bucket is your QSBS stock is acquired in a stock transaction by a company whose stock is not QSBS, such as if a public company were to be the purchaser. So, in this case, the stock you received would maintain the same holding period and QSBS treatment, but only to the price of the exchange. You can claim QSBS up to the fair market value on the date of the acquisition and future appreciation would not be QSBS eligible. But you need to remember that the five-year holding requirement is still required in that instance.

Third bucket is a cash purchase. So, the good news is there's an opportunity under 1045 of the Internal Revenue Code to roll over those gains from the sale of a qualifying QSBS into QSBS of another company. The holding period is tacked onto the holding period for the replacement QSBS. A very important timeframe is that the rollover must occur within 60 days, and that's a hard and fast 60 days.

Ann Lucchesi: Yeah. I'm going to jump in here. Thank you, Danielle. And I just wanted to kind of give a personal situation that I walked the founder through and why it's really meaningful to understand some of the basics around this M&A piece. A few years ago was sitting down with a founder in New York and talking to him about some of the important things to think about, including understanding qualified small business stock exclusion. And as I'm explaining this and talking through, "Hey, it matters whether or not you get acquired before the five-year mark and what that acquisition looks like," he's like, "I need you to stop right there. I've got three LOIs on the table right now. The first one is to be acquired stock for stock from a publicly traded company. A second offer is to acquire the IT directly, and the third one's actually a cash offer."

He said, "I need you to walk me through this so I can understand because it sounds like it'll have an impact to which one of these I decide to choose." So, we walked through it. We also referred him to a tax advisor who could really go deeper on this subject matter. And he came back to me about a month later and he said, "I can't thank you enough for this. That conversation completely changed which offer I took." He ended up taking the offer from the publicly traded company. He got comfortable enough that it was a company who shares he would want to continue to hold for another two years because he was only at the three-year mark. But it made an enormous difference in his final outcome of the money that was put in his pocket.

So, important to kind of at least understand these at a high level, so that you can reach out to experts when you have to make any decisions around these things. I think we're going to wrap up our discussion. We're going to start with just really quickly high level. QSBS can be the most important tax exclusion for founders, investors, and employees. So, it's great to understand it, great to reach out and get advice around it. I can't emphasize how important it is to seek advice along the way, talk to your advisors. So, advisors could be everything from your commercial banking partner to your financial advisor, get some tax and legal advice, particularly as your company grows.

This isn't a point in time that we're going to point to, even though I would say, you get the exclusion when you sell, so at that point in time, but there's so many measurements along the way in order to make sure that you hit all the right metrics on this, Understand those key aspects and focus on not only how to meet the qualification, but how to retain the qualifications of your shares up until the point of liquidity. You'll all be receiving the recording and slides over the next couple of days and an FAQ over the next month or so. Please send it to any founders, investors or employees that you think would benefit. To discuss your unique situation, please contact our experts directly at the email addresses provided.

Now, we're going to move on to Q&A and we've left, it looks like plenty of time for this, which is great because there are an unbelievable number of nuances to this particular rule. I wanted to start with something that came up repeatedly from the questions that were submitted ahead of time, and I think there's probably some on our chat box as well, which is, how do we think about documentation? What are the best practices? When do I need to start? What does the law tell me I have to do? Do I need to let my investors know? So, I'm going to hand this off to Christopher to address this so he can tell us what's required under the law and then maybe best practices for how to think about this.

Christopher Karachale: Yeah. Thanks, Ann. Well, the technical answer is zero. The 1202 in the statute, if you read it, it says, "We're instructing treasury to issue regulations about what companies need to do to keep track of QSBS." Those regulations, that's never come out. So, as a technical matter, you can start your company. You're a founder, you start your company, you do this, and at year 5, you sell your QSBS, and on your tax return you write $10 million and you exclude it with QSBS and you file your tax return, exclude it and that's it. So, you don't have to do anything.

Now, I think that's probably a bad idea, for most people. But I mean, it's a delicate balance because, you know, I think for a lot of founders... First of all, a lot of founders don't even know about QSBS when they're starting out, and that's okay. You just don't want to end up making a footfall. So, Ann mentioned making an S selection at the very beginning, or something like this. There are some basic mistakes that founders make that pretty much prevent them from ever getting QSBS, making an S selection is the biggest, or doing those redemptions. Ann mentioned those redemptions. But those are kind of just like discreet rules.

In terms of documentation, I think the most important is, again, to sort of think about from the individual shareholders' standpoint and from the company standpoint. From the founder's standpoint, make sure that you have your stock purchase agreement and your 83(b) and everything else to help show that you're going to hit the 5 years. So, you have to keep track of all that stuff. And I know a lot of founders... You know, we see founders who say, "Hey, you know, we never paid for the shares," or, "I bought all the shares and then I gave them to my co-founder." This creates a huge QSBS problem because as Ann said before, you have to buy the shares, you know, you have to get them in exchange for cash.

And so, I think the more that from the shareholder side, you can keep documentation showing that you've got those shares in exchange for your small cash contribution or your 83(b) with this sweat equity, whatever it is. From the company side, you know, it's just about keeping good records, And this is not just about QSBS, but generally, like a lot of founders start out...I talk with most founders and they call me and they say, "Is it QSBS?" And the first question I say is, "Well, let me ask you a question. When you were starting this, did you guys live on ramen and maxed out your credit cards?" And they say, "Yes, we lived on ramen and maxed out our credit cards. And I say, "Okay, you're gonna get QSBS." I don't care what the rest of the document...because that's quintessential founder's stuff.

But joking aside, I think just keep track of the documentation. You're going to have to go and get those 409A's to issue options to your early employees. You're going to go out and hopefully get venture funding. And keep a record of all that information because as we talked about, whether it's about that 80% active business test showing fair market value throughout the lifecycle of the company, or keeping those tax returns, I think founders have a lot of stuff to worry about and when they're starting out, they don't have a lot of money to get good accounting or tax or any of this. And so, the key is to just try and keep a good record of all the documents, even if you don't know what it's for, just to make sure that when you do get to the end, we can go through and look at your financials even before they were audited, or your tax returns and everything else to make sure you meet all these various requirements. Ann or Danielle, maybe you guys have a different perspective.

Ann Lucchesi: No, I think that was really helpful. I mean, one of the things I do tell companies from a company level is oftentimes they're exceeding that threshold off and on a round raise. And so it's a good time to kind of look at the cap table and dig into it if you want to make sure that you've got some documentation at a company level. But it's one of those things where I find it very difficult is if you've owned the shares for more than five years, you get acquired, you file and you didn't have any of that. To go back and get it from the company that acquired you will be very difficult, if not impossible.

Christopher Karachale: Right. That's a super good point. So, remember, in order to know that... This is a huge underlying problem in QSBS. Ann and Danielle and I have talked about all these different rules, and the only way you know if the company meets all these criteria is if you can look at the tax returns, and the audit financials, and everything else. And for an early employee or like an employee number 80 or 90 who might have exercised her options and gotten QSBS, she's not going to have access to that information. So, there's kind of an information mismatch in the way the statute's designed, you know, because if the company's not affirmatively providing documentation, that makes it hard for the early employee. The founders will get them, they know.

But sometimes companies will, you know, there's that QSBS checklist that you see floating around where they'll fill that out, or sometimes, for example, companies will hire us to write a letter, you know, explain why the company qualifies, and then that letter gets handed out to early employees or VCs. So, you know, companies, by the time you raise your B round or your C round, at that point, the company's probably not gonna fail. And so, something that sometimes founders will do is try and do some analysis, not just for themselves, but also something that can go out to the other shareholders who may have QSBS, so they know.

Ann Lucchesi: Yeah, exactly. Well, thank you for that, Christopher, I'm going to ask you another one that I know you and I have talked about before, that we run into frequently, which is, "Hey, what about safe notes or convertible notes? How are they treated? Do they get the proper treatment? Because these are pretty common in this day and age."

Christopher Karachale: I don't know. I mean, I don't know anything about...like that's the problem., you don't know. Let me tell you what we do know. The legislative history, you talked about 1993, the legislative history to QSBS from 1993 says, "Options, warrants and convertible debt can be QSBS, but only on conversion. Options, warrants, and convertible debt can be QSBS, but only on conversion." So, safe is not an option, it's not a warrant, it's not convertible, it's not debt. It's sort of hybrid instrument. And you know, the Y Combinator safe, when you read it says, "For purposes of 1202, this is considered stock." 

I can hold this up and say, "For purposes of the rest of this call, this is a pen." But it's not, it's a pencil. So, the mere fact that the safe itself says that it's QSBS doesn't make it QSBS. The rule says it has to be stock, an investment in the company. So, I think it's an open question. But I do think QSBS, and again, going back to legislative history from '93, it says, "We want to encourage investors to put money into startups that are likely to fail." That's what the legislative history says right at the beginning from '93. And so, most startups now in the valley, they're not going to issue you stock.

The only way a seed investor or a friend and family person could come in is by getting the safe, because they don't want to price the company or whatever else. So, I do feel like, so maybe the safe, because that legislative history with options, warrants may be technically as involved, but I think in substance, you know, if I'm buying the safe because I want to invest in that company, I think that's QSBS. But as I say, this is an open question.

Ann Lucchesi: Yeah. Thank you. And I think the important takeaway on a lot of these things is there's a lot of nuance and you really do have to rely on your accountant. And in fact, oftentimes the accountants are coming to you, I know Christopher, to get an opinion written because there is so much nuance around this. And so, just be prepared to know that it isn't all black and white and easily answered. One of my colleagues has been sifting through the many Q&A questions that have come through. So, I'm going to have him read out a few to the three of us so that we can answer. What's on your mind, Brandon?

Brandon Frandsen: So, we have a lot of great questions, and the way I've read through these is to try to pick the ones that will apply to most individuals. Now, this question we've already touched on, but I want to make sure everyone relates to this information well. So, the first question is, are employee options qualifying for QSBS treatment?

Ann Lucchesi: Yeah. And so, I'll go back and I'll answer it the way I did upfront. This does come up a lot. So, again, owning the option by itself is not a qualification for QSBS. It is at the point in time that you exercise. So, you have to have put forward the cash to have actually exercised the options, and that's when your measurement is going to begin. So, the company's still going to have to be underneath $50 million in gross assets at the time you exercise the shares for them to qualify. If you have options that have something known as early exercise ability where it allows you to exercise prior to vesting in them, you are allowed to do that.

And then if you took your 83(b) election, which says, "I'm going to take my taxable consequence at this point in time," and it's much deeper than that, I'm sure Christopher would love to correct my language around that. But from essential point of view, it says, "I'm going to take my taxes right now and start the clock," and that's something, by the way, that has to be filed within 30 days of the time you make your exercise, then the QSBS would apply at that point in time on those shares, even though the vesting and true ownership doesn't occur until downstream, for purposes of QSBS, that would be your point in time. If you don't take that, once again, every vesting point along the path of these early exercise options with no 83(b) election will become its unique cost basis and have to be looked at for QSBS separately. And if Christopher wants to jump into that, he can.

Christopher Karachale: No. That's right. That's right.

Brandon Frandsen: So, Ann, the follow-on question for this, make sure we cover all the bases here is, do restricted stock grants qualify for QSBS? And I think there's a practical answer and a theoretical answer. And also, is the acquisition, the date of vesting or the grant date?

Ann Lucchesi: I want to be a little careful, I'm going to jump into this and maybe Danielle will want to follow on, but I often hear terms thrown around a lot with restricted stocks. So, I'm going to try to designate different things. A true restricted stock award, you actually receive the shares at that point in time and then you are vesting into the right of ownership, but shares are issued at that point in time. Typically on these, again, you want to take that 83(b) election, and that's an important thing. So, if you did that, you took 83(b) election, when they reissued to you, they would immediately start the clock.

Now, conversely, I'm going to talk about something known as RSUs or restricted stock units. Some people call them restricted stock, but they are very different. In restricted stock units, the stock is not issued until generally it's vesting, but there could be a secondary trigger in there as well for some of the private companies, usually a liquidity event would do it. So, those two things will have to happen before the shares are issued. On those, again, we're going to look at the date of issuance. And so, by far and large, most of the time when we're looking at RSUs, they're issued in later-stage companies and the stock is not issued until there is either an acquisition or an IPO.

And so, often those would never qualify, just depending on how you look at the terms. But again, that 83(b) election's going to be important on anything known as restricted because you're electing a point in time with the IRS at your taxable point in time, and that would start that clock for QSBS, as long as it meets all the other metrics.

Brandon Frandsen: Next question, and I think this is a good one. It comes up quite often once individuals have had that liquidity event and the stock is publicly traded where they're holding the stock and they want to minimize their downside risk. So, I'm going to avoid the different types of derivatives and just say, if someone owns what is QSBS stock and they decide to enter some sort of contract that minimizes their downside, what are the consequences of that?

Ann Lucchesi: Yeah. Danielle or Christopher, do you guys want to address that one?

Brandon Frandsen: So, think in this way, like a short position, a forward contract on the shares.

Christopher Karachale: Well, you've have to be careful, because there are those restrictions put for QSBS and calls. So, it doesn't come up very often, but you do have to be careful if you're offsetting, you know... Think about it from, you've locked in this QSBS exclusion, once you have QSBS and you've hit the five years. If you're going to put in some offsetting short position, you know, Congress doesn't want you to do that if you've already locked in QSBS. But Brandon, I think what's kind of more interesting, and this comes up a lot, we see this with early employees who get a forward contract, you know, and go out and have somebody help them give a bunch of money so they can exercise options and get QSBS before they go over the $50 million. So, it's like a forward contract where, you know, the early employee gets the money and then has to pay back somebody after the IPO or whatever else with those shares.

That itself I think can sometimes create the short position as well. So, after IPO, once it's publicly traded, I think the offsetting short, the risk is kind of minimized, but I think like employees who are trying to early exercise and get that money, not early, to exercise, they're borrowing money from some investor to exercise shares with the point that they have to pay back that investor after the IPO, that introduces some of the short positions you have to worry about.

Ann Lucchesi: Yeah. And I think what I would throw in there is, you know, again, the uniqueness of these situations. Your accountant is the one who's going to go to bat if there's a problem, if the IRS comes back and says, "Hey, I'm questioning this." So, rely upon your accountant's opinion in doing this because it isn't very black and white. It's very complicated and every situation is unique.

Brandon Frandsen: So, the next question I have for you realizing that there's probably a decent percentage of people on this webinar that might have had QSBS, filed their returns and not know. So, the question I'm going to ask Chris is probably going to have two answers. One for a certain group, one for another group. This individual rights, I had a business that was acquired in 2011. Again, that's 2011. Not knowing about QSBS, we paid long-term capital gains. Could I potentially get a refund? So, maybe answer it for that person and someone who made that mistake a little bit more recently than 2011.

Christopher Karachale: For that listener, the answer is no. I'm sorry. There's a three-year statute of limitation where you can go back and amend your returns to claim those refunds. So, you know, we work with a lot of founders and early employees and the IRS is not really auditing QSBS really. That may change and the IRS may start looking certainly with the funding, and again, I'm not suggesting anybody on this call, you know, play the audit lottery. You should know if it's QSBS or not. And as Ann said, talk with your accountant or get your tax attorney or somebody. But the issue is this, if you go ahead and file QSBS and take the exclusion, when you sell now, you know, I think the audit risk is pretty low and if you know it's QSBS, you're in good shape.

People when they go back and ask for a refund though, you know, if you ask for a $2 million refund from the IRS, your figure's on $10 million, you're avoiding tax on $2.34 million. The IRS, they're very nice people, but they don't necessarily like to give back large chunks of money without making sure that the person qualifies for that refund. So, if you're going to go back and claim and ask for the refund, you really have to make sure all these boxes are checked. So, even if it qualifies, the question is, are you prepared to go through an audit? Defend that, and make sure you can prove out every one of these elements really closely because I think asking for a refund, you're going to have to really prove it. So, make sure your ducks are all lined up.

Ann Lucchesi: Yeah. And I would agree. I have seen it done by the way, just in case anyone wonders. In 2018, we had a client who had not gotten advice around it and did go back and file the previous year's return and was able to claim it, but he definitely had his ducks lined up, as you might say. So, I think we're going to wrap it up. I want to thank all of you for joining us today. I hope you have found this informative. Our next webinar will focus on advanced equity compensation issues that private companies run into.

Please send us any questions, issues that you think we should answer in our follow-up survey here, and it's dropped into the chat, and then we can include that in our next webinar. Thank you all for attending, and thank you all of you experts out there that helped me with this.