Venture Capital and IRC Sec. 1202 Qualified Small Business Stock

There are many tax considerations for venture capital funds including IRC Sec. 1202 qualified small business stock (QSBS). On June 16, EisnerAmper hosted a virtual roundtable on the topic featuring Kayla Konovitch, partner in EisnerAmper’s Financial Services Group; Steve Franklin, partner at law firm Gunderson Dettmer; and Meghan Andersson, senior manager in EisnerAmper’s National Tax Group.

IRC Sec. 1202 allows certain shareholders to exclude up to 100% of their gain from selling QSBS if the stock was acquired after September 27, 2010, was held for at least five years, and was issued by a C corporation with less than $50 million in assets, among other requirements. The law was first enacted in 1993, for the purpose of promoting small business investment. Originally, the exclusion was 50%, subject to alternative minimum tax (AMT).  In 2010, the exclusion increased to 100% and was no longer subject to AMT.  Some states follow IRC Sec. 1202 and permit the exclusion as well.

The Build Back Better Act of 2021 would have returned the QSBS exclusion to 50% for taxpayers earning over $400,000. To date, the bill has not passed but is still under negotiation. If it does pass, it will probably not include a provision to roll back the QSBS benefit.

Some of the requirements to be eligible for the gain exclusion include:

1. Shareholder must hold the stock for at least five years.
   1. VC investors can qualify for IRC Sec. 1202 with respect to their pro rata share of pass-through gain only if they were already invested in the fund on the date the stock was acquired, and the fund holds the stock for at least five years.
2. The VC must receive the stock directly from the corporation.
3. Issuing corporation must be a domestic C corporation for the entire holding period.
4. Company’s gross assets cannot exceed $50 million (tax basis) at any time from 1993 through immediately after the stock issuance.
5. There is also an active business requirement. During substantially all the holding period, at least 80% of the assets must be used in the active conduct of a qualified trade or business.
   1. This includes a 50%-owned subsidiary
   2. A list of exempted businesses that are not qualified can be found in IRC Sec. 1202(e)(3)
   3. There is a lot of grey area on what constitutes a qualified trade or businesses. Thus, it is important to have a clear understanding of the business in which the corporation is engaged and to carefully analyze the facts and circumstances.

One area of debate is simplified agreement for future equity (SAFE) notes.  It is unclear whether they should be treated as stock for QSBS purposes.  It is important that VC managers discuss this with their tax professionals.

It is also important that the investing fund get representations and warranties from the corporation that it has met all the IRC Sec. 1202 requirements at the time of investment, and also obtain covenants that the corporation will confirm at the time of the VC fund’s exit that the QSBS requirements were met during the VC fund’s holding period of the stock. 

When a VC fund sells or distributes QSBS stock to its investors, and there is uncertainty as to whether it qualifies for the exclusion, the best practice is to send a separate letter giving the investor supplemental QSBS information so that the investor can make an informed determination regarding whether to take the exclusion. 

The QSBS benefit was made for the venture capital world, and, when structured correctly from the outset, presents an excellent tax benefit for venture capital funds and its investors.