Your business is doing well, acquisition discussions are starting with potential buyers and you have met what you think qualifies your Company for QSBS treatment (also referred to as 1202 stock) and hope to someday avail yourself of utilizing the benefit of NOT paying tax on the GREATER of $10 million dollars or 10 times your investment. Life is good, or so you believe?
You are aware, of course, of the bigger, more well-known hurdles of the qualifying for QSBS treatment that are typically discussed, such as:
1) You have received original issue stock for a C Corp. issued to you, directly, by the Corp.;
2) Your business is in the qualifying field of business for QSBS treatment;
3) You received the stock when the value of the assets was under $50 million dollars; and
4) You ended up holding the stock for more than 5 years.
But did you know that sometimes events can occur after the fact that can taint some individual’s holdings into disqualifying territory? Let’s explore these now.
The first hurdle that warrants discussion is the rule around 80% of the assets on the balance sheet MUST be used in the qualified business activity during substantially all of your holding period. Basically, the plan should be to use the cash on the balance sheet for R&D and the pursuit of the expansion of the business. The IRS looks at a 2-year time horizon during which the funds should be used, and, if the company has excess “working capital”, then it could taint the QSBS status. Once your business has been in existence for more than 2 years, the test is that no more than 50% of the assets are eligible for working capital, and taking into account the general rule of 20% can be used outside of the business activity, a total of a 70% threshold must be met to remain as a QSBS in “good standing”. If you don’t meet either threshold, then stock issued from this test point on will be Non-QSBS and prior issued shares may also be disqualified for failing the standard of meeting these requirements during “substantially all of your holding period”.
The other concern you may need to track is that certain redemptions during the company’s life could taint the stock for certain investors. The first to look at is whether the company redeemed more than a “de minimis amount” of shares during a four-year period, two years before the event of the redemption and two years after. The IRS defines more than de minimis as the seller getting more than $10,000 and a redemption by the corporation of more than 2% of the stock held by the taxpayer or a related person. So if a founder sells stock back to the company and sells, say 10% of his/her shares, those shares that are issued two years before the transaction and two years after the transaction will not be deemed QSBS shares for stock issued to the redeemed shareholder or a related party during that time window.
The second provision has to do with a test that still looks at the de minimis tests above but also layers in a test of the value of the redemption of the stock. For two years, starting one year before the stock was redeemed and ending one year after the redemption date, if more than 5% of the total value of the corporation’s stock is redeemed, then all stock issued during this two-year period to any shareholder will be disqualified from QSBS status.
So just make sure when starting your next new business that you have looked at not only the typical QSBS qualifiers, but also the asset test and the redemption tests discussed above. Better to know now, than to find out 5 years from now with very different expectations. That way, perhaps, you can retain the benefit of 1202 stock for that exit! Feel free to reach out to me or any of our KN+S professionals for additional guidance around these rules.
Jeffrey Solomon, CPA, is the Managing Shareholder at Katz, Nannis + Solomon, P.C. If you have any questions or would like to speak with one of our professionals, please contact our office at 781-453-8700.