The Qualified Small Business Stock tax exemption is extremely valuable for VC-backed startup founders, employees and investors. However, the IRS does not want to offer the benefit to certain industries, like hedge funds. And VC-backed startups with lots of cash on the balance sheet can look disturbingly like a hedge fund.
Specifically, the way a startup manages its cash reserves can have significant implications for maintaining QSBS eligibility, a factor that can offer substantial tax benefits down the line. Here, we dive into the key considerations startups need to be aware of to navigate these waters successfully.
We also strongly recommend working with an experienced attorney when dealing with this tax exemption.
The Active Business Requirement and Your Cash
Under the Active Business Test, a crucial QSBS criterion, at least 80% of your company’s asset value must be actively used in the conduct of your business throughout most of the investor’s holding period. However, the plot thickens with the Securities Test, stating that failing to keep stock and securities of non-subsidiary corporations below 10% of your net assets can disqualify you.
In non-IRS talk, what that means is that if a startup has a ton of cash that it’s investing to earn a yield (and push out its cash out date) then the IRS may consider it a hedge fund, and therefore blow the QSBS eligibility.
The silver lining?
The Working Capital Exception allows cash and similar assets to be counted towards the active business if they’re earmarked for near-term working capital or expected to finance R&D within two years AND they are invested in approved securities.
The Working Capital Exemption
The Working Capital Exemption is a crucial aspect of the Qualified Small Business Stock eligibility criteria, particularly under the Active Business Test. This exemption allows certain assets, which might initially seem passive or non-operational (like the cash or short-term investments that VC-backed startups have after a fundraise), to be counted as active assets used in the conduct of a qualified trade or business.
Definition of Working Capital: Working capital generally refers to the funds a company needs for its day-to-day operations and to meet its short-term obligations. Under the exemption, cash and liquid investments can be considered working capital if they are earmarked for operational expenses, growth initiatives, or other business activities that are expected to occur within a relatively short period, typically within two years. So you need to show that you are going to use your capital in two years. Note that this IRS definition is similar but a bit different than the traditional accounting definition of working capital.
Best Practices for QSBS Compliance when Investing Startup Cash
Avoid Non-Government Debt: If more than 10% of your assets are other companies’ securities - like stock or debt - you will likely fail the active business test, and thus blow your QSBS eligibility. Therefore, choose government debt, like T bills or investment funds that put 100% of their assets into government debt. The government doesn’t want you to look like a hedge fund, so avoid any investments in other corporations, even publicly traded stock is a no.
Short-term Investments: Under the working capital exception in the Internal Revenue Code, Section 1202(e)(6), a corporation needs to have a use for the company’s cash in the next two years. So having investments that mature in over two years could very easily be interpreted by the IRS as the business not planning on using the cash in the correct amount of time. Keeping your corporate cash in short-term instruments like Treasuries or Money Market Funds is wise. This strategy aligns with QSBS requirements by ensuring your assets are considered active in your business operations.
Have a Plan That Uses Capital in Two Years: Build a financial model that shows you running out of cash in two years. These projections should be reasonable and defensible, and it’s not out of the question to use a more conservative model that you used to raise VC funding. A set of projections where you grow revenue more slowly and expenses are higher can be quite reasonable, as many startups fail to achieve the projections they put forth in a slide deck when raising funding. Just be honest and defensible. This documentation can guide your investment decisions, ensuring they meet the QSBS active business criteria.
More on the Exemption
We have an entire article on QSBS (and one even on their interaction with SAFE notes), but at a high level, Qualified Small Business Stock refers to a special designation under the U.S. tax code that offers significant tax benefits to investors and shareholders of certain eligible small businesses.
Specifically, QSBS is outlined in Section 1202 of the Internal Revenue Code and allows for the exclusion of a portion, and potentially up to 100%, of the capital gains from federal income taxes that an investor realizes from the sale or exchange of QSBS held for more than five years. This powerful tax incentive is designed to stimulate investment in small, innovative companies by providing a substantial tax break on long-term investments, thereby encouraging the flow of capital into sectors that are critical for economic growth and innovation.
To qualify as QSBS, both the issuing company and the stock issued must meet specific criteria, some of which we outline in our main QSBS article.
Conclusion
For startups aiming to maintain QSBS eligibility, the intersection of cash management and tax compliance is a delicate balance. By understanding the implications of the Active Business Test and navigating the Working Capital Exception wisely, startups can ensure their cash management strategies bolster their QSBS status rather than jeopardize it. This strategic approach not only supports immediate operational needs but also sets the stage for significant tax advantages during exit scenarios, making it a critical aspect of long-term financial planning.