Tips for Realizing Qualified Small Business Stock Benefts for Fund Investments by Neal Gerber Eisenberg

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January 26, 2021

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Tips for Realizing Qualified Small Business Stock Benefits for Fund Investments and Certain Convertible Instruments (Part Two of Two) By Michael B. Gray, Jeffrey S. Shamberg and Eric M. McLimore, Neal, Gerber & Eisenberg LLP

Although many entrepreneurs and investors are intrigued by the potential tax advantages of holding Qualified Small Business Stock (QSBS) under Section 1202 of the Internal Revenue Code of 1986 (Code), many avoid the approach due to a misconception that it is only available when directly investing in early-stage businesses. There is, however, a range of techniques for securing QSBS tax benefits in a broad number of contexts, including when investing through a private fund with non-traditional instruments (e.g., convertible instruments). This two-part series provides insights about QSBS tax treatment and practical tips for how fund managers can take advantage. This second article explains how fund investments, Simple Agreements for Future Equity (SAFEs) and convertible instruments can receive and preserve QSBS status. The first article identified techniques for converting certain existing businesses operated through nonqualifying “flow-though” or “pass-through” entities into qualified small businesses (Qualified Small Businesses). For coverage of another tax-advantageous investment technique, see “Final Regulations Clear the Way for PE‑Backed Opportunity Zone Investments in 2020 and Beyond”

(Mar. 31, 2020); and “What Unique Tax and Structuring Challenges Do Qualified Opportunity Funds Present to Sponsors and Investors?” (Jun. 25, 2019).

Types of Investments Fund Investments Under certain circumstances, fund investors can receive allocations of gain from a fund’s sale of QSBS and exclude the gain from their income as a qualifying sale of QSBS. For private funds structured as partnerships, QSBS treatment is only available if fund investors hold their interests when the fund acquires its QSBS investment, throughout the five-year holding period and when the fund disposes of its QSBS investment. Multiple Investment Rounds As fund investments are commonly structured with multiple investment rounds, QSBS treatment is often unavailable for investors in later-stage rounds – even if they had already invested in earlier rounds. Thus, if an investor were to increase its percentage ownership interest in the fund in a subsequent investment round, the amount of gain the investor could 1

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exclude on the fund’s subsequent sale of QSBS is limited to the investor’s percentageownership interest when the fund originally acquired the QSBS.

and Regulatory Environment in Luxembourg and the E.U.” (Apr. 14, 2020).

In addition, if an investor acquires its interest in the fund after the fund acquires QSBS, then any income flowing through to the investor would not be eligible for QSBS tax benefits, regardless of whether earlier-stage investors remain eligible to claim QSBS treatment. Thus, even though a subsequent investor in the fund may dilute the percentage-ownership interest of prior investors, only the earlier investors holding interests at the time of the fund’s acquisition of QSBS can exclude from income allocations of gain from the fund’s sale of QSBS.

In addition, a fund is permitted to distribute QSBS to a fund investor that owned its interest in the fund when the fund acquired the QSBS without the investor losing the ability to claim the benefits of QSBS on a subsequent disposition of the QSBS.

To be clear, later investors may receive allocations of gain from the fund’s sale of QSBS, but the gain would not be eligible for the QSBS exclusion if the investor did not hold its fund interest when the fund acquired the QSBS. If the fund acquired additional QSBS after a later-investment round, however, then fund investors at the time of that acquisition of additional QSBS could be eligible for QSBS treatment based on their percentageownership interest in the fund at that time. Multiple rounds of fund investments are common, and the rules about an investor’s eligibility for the QSBS exclusion are limiting. Therefore, investors should assess a fund’s investment holdings and expectations for future portfolio investments at each investment round to determine their eligibility to claim QSBS treatment. For more on fundraising, see “Impact of Economic Uncertainty on PE Fundraising and Fund Formation Efforts (Part Two of Two)” (May 26, 2020); and “Distribution, Fundraising

In‑Kind Distributions

Although that tactic is less common outside of a closely held fund or family office, a fund’s distribution of stock in a portfolio company may be useful if a fund does not wish to hold its investment for the five years necessary for QSBS treatment. In contrast to distributions, if a fund contributes QSBS to another partnership (e.g., a subsidiary fund, alternative investment or financing entity), the benefits of QSBS will be lost to the new fund and its owners.

Simple Agreement for Future Equity The U.S. federal income tax treatment of SAFEs is unclear. Depending on the terms of the SAFE, the instrument might be treated as preferred or common equity; debt; or a prepaid forward contract. To be treated as QSBS, an investment must be treated as equity. Consequently, investors in SAFEs should be aware that the IRS may not agree with their characterization of a SAFE as equity or as QSBS. For more on preferred equity, see “The Growth of Preferred Equity: Features of the Hybrid Debt/Equity Solution and Its Use for Fund Level Liquidity (Part One of Two)” (Dec. 1, 2020); and “A Comparison Between Two Liquidity Solution Tools: Preferred Equity and NAV Facilities” (Oct. 13, 2020). 2

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Further, an investor may not be treated as acquiring QSBS until the SAFE is exchanged for “traditional” equity and, in that case, provided that the requirements for QSBS are satisfied at the time of issuance. Thus, depending on the terms of the particular SAFE instrument, the beginning of the five-year holding period for QSBS purposes may not begin with the acquisition of the SAFE but, instead, upon its conversion into traditional equity.

Convertible Instruments Many investors acquire stock through the exercise of stock options or warrants, or the conversion of convertible debt. Although each event may be treated as satisfying the original issuance requirement, the determination of whether the issued stock is QSBS will be made at the time of the exercise or conversion. Thus, an investor may be left holding stock that is not QSBS if the aggregate gross assets of the business exceed $50 million when the instrument is exercised or converted, or if a disqualifying redemption occurs within the proscribed time periods relative to the exercise or conversion. Consequently, holders of options, warrants and convertible debt should monitor whether the business continues to satisfy the active business and aggregate gross asset requirements, and they should consider negotiating the right to force an exercise or conversion while the aggregate gross assets of the business remain at or below $50 million.

Disqualifying Redemptions Congress enacted the QSBS provisions to incentivize investments in early stage businesses, which it perceived as historically

lacking seed investment. Consequently, QSBS treatment is not available for stock that does not meet the original issuance requirement. For more on seeding fund managers, see “The New Trend in PE Fund Seed Investments, Unique Deal Features and Several Options for Seed Sources” (Mar. 17, 2020); and “Study Examines Key Terms in Seed Deals: Structuring the Seeder’s Interest, Key Person Covenants and Lock-Ups (Part One of Two)” (Oct. 12, 2017). Although stock acquired from other owners is clearly ineligible for QSBS treatment, direct stock issuances from an otherwise qualifying business also may be ineligible if the company has engaged in certain “significant” or “related party” redemption transactions during proscribed periods surrounding the issuance. According to the legislative history, Congress perceived certain redemptions as assisting in the avoidance of the original issuance requirement. Therefore, investors should be vigilant that a company has not engaged in certain related party or significant redemptions in the one‑ to two‑year period before and after: • making an investment in an otherwise qualifying business; • converting an existing flow-through partnership or LLC into a C corporation; or • exchanging one type of investment instrument into preferred or common stock. Under the right circumstances, it may be possible for investors to acquire stock directly from prior-round investors and to exchange it for stock in a new investment round without causing a redemption that disqualifies any prior or future investments. Although the stock issued to the new investor in exchange for stock acquired from a prior investor would not 3

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qualify as QSBS, that technique may be beneficial if the company is nearing the $50‑million limitation on qualifying as a small business or if the investor desires additional shares of a certain tranche of stock. If not structured correctly, however, that same transaction could be treated as a disqualifying redemption by the IRS under the steptransaction or another common-law doctrine. In addition, an improperly structured transaction could disqualify previously or subsequently issued stock from qualifying as QSBS. Also, priorround investors may be reluctant to sell before they have satisfied the five-year holding period.

Alternative Exit Scenarios Although the ability to exclude the greater of $10 million and 10 times basis is already a substantial benefit, some investors are able to further enhance the benefit. An investor that sells QSBS and makes a timely acquisition of QSBS from another issuer may be eligible to roll over the proceeds and defer the recognition of taxable gain up to the cost of the replacement QSBS. In addition, some owners of QSBS may exit their investments by merging the Qualified Small Business with a non-qualifying business (e.g., acquisition by a large public company). If the merger or acquisition is structured to qualify as a non-taxable incorporation or reorganization under Sections 351 or 368 of the Code, the owners of the QSBS can defer recognition of tax and continue to take advantage of the QSBS exclusion to the extent of the gain at the time of the merger or acquisition. Finally, a limited exception from the original issuance requirement exists for holders who acquire their QSBS by gift. Therefore, savvy

investors may consider engaging in trust and estate planning by transferring QSBS to trusts for the benefit of family members. When QSBS is received by gift, the recipient is treated as receiving the QSBS in the same manner as the donor. That approach can satisfy the original issuance requirement, with the recipient treated as having held the QSBS for the donor’s pre-gift holding period. See our three-part series: “Tax Issues and Estate-Planning Obstacles Associated With Transferring Carried Interest in PE Funds” (Jan. 14, 2020); “Estate-Planning Strategies for Transferring Rights to Carried Interest in PE Funds” (Jan. 21, 2020); and “Possible Solutions for Tax Problems With Valuing Gifts and Sales of Carried Interest in PE Funds When Estate Planning” (Jan. 28, 2020).

Conclusion Section 1202 provides extraordinary benefits to equity owners of certain C corporations, and should be considered at business formation and when seeking investment financing. Although there are strict requirements to qualify as QSBS, many common investments are either eligible for QSBS treatment or can be converted into QSBS. Consequently, owners and investors should be familiar with the requirements and disqualifications for QSBS treatment, and should not enter or exit investments before determining their eligibility for tax-free treatment. Michael B. Gray is a partner, and head of the private equity, venture capital and growth companies practice, at Neal Gerber Eisenberg in Chicago. His practice concentrates on a variety of complex transactional and corporate governance matters, including mergers and 4

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acquisitions; PE and venture capital investments; intellectual property agreements; and the structuring of corporations and partnerships, including limited partnerships and LLCs. He has extensive experience with fund counseling, including representing GPs and LPs with fund formation; advising investors on their fund investments; and advising funds on their formation and compliance needs (both onshore and offshore). Jeffrey S. Shamberg is a tax partner at Neal Gerber Eisenberg in Chicago. He works with clients to minimize tax obligations arising out of business formations; joint ventures; financings; equity offerings; reorganizations; mergers and acquisitions; dispositions; and loan workouts. He also represents business entities and high net worth individuals in all phases of tax controversy matters with the IRS and the Illinois Department of Revenue. Eric M. McLimore is a senior associate at Neal Gerber Eisenberg in Chicago. He advises corporations, partnerships and individuals on international, federal, state and local tax planning, transactional and controversy matters. He focuses on tax issues concerning income; employment; and sales and use tax issues, as well as controversies arising from business formations and reorganizations; mergers and acquisitions; and other business transactions. The authors wish to thank Neal Gerber Eisenberg attorneys Joshua A. Klein, Cristina W. DeMento and Scott J. Bakal for their assistance with preparing this article.