Techniques for Preserving Qualified Small Business Stock Benefits for Early‑Stage Investments by Neal Gerber Eisenberg

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January 19, 2021

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Techniques for Preserving Qualified Small Business Stock Benefits for Early‑Stage Investments (Part One of Two) By Michael B. Gray, Jeffrey S. Shamberg and Eric M. McLimore, Neal, Gerber & Eisenberg LLP

Entrepreneurs and investors – ranging from venture capital, PE, hedge funds or family offices – working with early-stage businesses have become increasingly familiar with the potential tax advantages of holding Qualified Small Business Stock (QSBS) under Section 1202 of the Internal Revenue Code of 1986 (Code). Although entrepreneurs and investors have become aware that qualifying investments in QSBS may reduce or eliminate federal income taxes on future exits from their investments, uncertainty remains about certain techniques for transforming existing investments into QSBS.

and “Current Tax Challenges for Funds With European Investments” (Sep. 29, 2020).

Overview of Section 1202 Although Section 1202 has existed since 1993, the investment community did not express much interest at first because the benefits it provided were limited in comparison to the costs. Section 1202 has become more relevant, however, and investors increasingly are demanding that their investments be QSBS eligible.

This two-part series details the primary tenets and considerations for fund managers to obtain favorable tax treatment from holding QSBS. This first article discusses some techniques for converting certain existing businesses operated through non-qualifying “flow-though” or “pass-through” entities into qualified small businesses (Qualified Small Businesses). The second article will address how fund investments, Simple Agreements for Future Equity and convertible instruments can receive and preserve QSBS status.

The increased significance of the QSBS exclusion can be traced to two primary events. First, between 2009 and 2010, the percentage of eligible gain on a sale of QSBS that could be excluded under Section 1202 was increased twice, first from 50% to 75% in 2009, and then from 75% to 100% in 2010. In addition, gains from the sale of QSBS were excluded from the alternative minimum tax (AMT) and net investment income tax. Second, in 2017, the Tax Cut and Jobs Act of 2017 (Tax Act) reduced the U.S. federal corporate income tax rate from 35% to 21%.

For coverage of additional tax guidance, see “How the Proposed Carried Interest Regulations Could Affect Fund Managers” (Nov. 10, 2020);

See our two-part series on the impact of the Tax Act: “Treatment of Carried Interest and the Business Interest Deduction Limitation”

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(Oct. 15, 2019); and “Cross‑Border Investments, GILTI and the Pass‑Through Business Income Deduction” (Oct. 22, 2019). Before those changes, the relatively high effective tax rate on C corporations, combined with a potential loss of any Section 1202 benefits due to the AMT inclusion, caused many PE sponsors to structure their investments without regard to qualifying for Section 1202. After those changes reduced the disadvantages to qualifying an investment under Section 1202, then more investors have become willing to pay an entity-level tax, hold an investment for the requisite five-year period and navigate the available investment exit scenarios to obtain QSBS treatment.

Four Primary Requirements

Unless the requirements for investing indirectly through a pass-through entity are satisfied, investors must acquire their QSBS directly from the Qualified Small Business or an underwriter in exchange for money or property other than stock, or as compensation for services. 2) C Corporation Tax Entity An investment will only qualify as QSBS if the underlying Qualified Small Business is a domestic C corporation for U.S. federal income tax purposes. Thus, an LLC that has “checked the box” to be taxed as a C corporation can qualify as a Qualified Small Business. For more on C corporations, see “New Tax Law Carries Implications for Private Funds” (Feb. 1, 2018).

Section 1202 incentivizes investments in certain businesses by allowing eligible investors to exclude the greater of $10 million or ten times their aggregate adjusted basis (i.e., adjusted “cost” basis) on the sale of QSBS that has been held for more than five years. Thus, the following are the four primary requirements to obtain QSBS tax benefits.

3) Qualifying Business Investment

1) Eligible Investors

A corporation also must generally devote at least 80% of its assets to the active conduct of a qualifying business, although there are exceptions for start-up ventures, working capital and certain research activities. There are limitations on the amount of investment stock or real estate a Qualified Small Business must hold, and any assets or operations of subsidiary entities are treated as directly held and performed for purposes of the requirement.

Eligible investors include any taxpayer other than a corporation that obtains QSBS on “original issuance.” Although direct investments in Qualified Small Businesses by individuals and trusts generally qualify, there are strict requirements for indirect investments made through: • pass-through entities such as partnerships; • LLCs treated as partnerships for U.S. federal income tax purposes; or • S corporations. ©2021 Private Equity Law Report. All rights reserved.

To be QSBS eligible, a corporation must satisfy active and qualifying business requirements for substantially all of the investor’s holding period. It also must have $50 million or less in aggregate gross assets at all times before and immediately after the stock is issued.

For more on real estate investing, see “Final Regulations Clear the Way for PE‑Backed 2

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Opportunity Zone Investments in 2020 and Beyond” (Mar. 31, 2020). A Qualified Small Business may operate only in certain “qualified” activities. Most technology, manufacturing and retail businesses are eligible. Although the corporation must be domestic, there is no limitation on the location of the business’ operations or the source of its income. There is a proscribed list of ineligible activities, and QSBS treatment is generally not available if services comprise a significant portion of the activities or if the reputation or skill of a particular individual is the principal business asset (e.g., doctors, lawyers, athletes, entertainers, etc.). In addition, many banking, insurance, farming, resource extraction, hotel, restaurant and similar businesses do not qualify. As the ineligible list of qualifying businesses is relatively straightforward, and the existing IRS guidance on what trades and business qualify generally has been favorable, most founders and investors make their own determinations as to QSBS eligibility instead of seeking private letter rulings from the IRS. Finally, businesses are only treated as “small” if their aggregate gross assets do not exceed $50 million. There are opportunities, however, for a corporation with a fair market value in excess of $50 million to issue QSBS. Thus, investors should not assume that QSBS treatment is not available merely because a company is valued at greater than $50 million for purposes of an investment round. For purposes of QSBS treatment, aggregate gross assets are generally valued as the amount of cash plus the adjusted basis of property held by the corporation. Therefore, certain businesses may actually have a fair market

value in excess of $50 million and still qualify if the business’s value is derived from goodwill or self-created intangible assets. As “contributed” assets are measured at fair market value, however, investors should take particular care to ensure the investment satisfies the QSBS requirements if a business converts to a C corporation after it becomes valuable or if valuable property has otherwise been treated as contributed to the business. Where a particular financing round may cause the business’s aggregate gross assets to reach $50 million, founders and investors should consider restructuring the investment into multiple rounds to maximize the number of investors acquiring QSBS. 4) Five‑Year Holding Period Finally, an investment must be held for more than five years to be QSBS. There are QSBS-specific holding period rules, and consequently, investors should not assume that non‑taxable exchanges of property for QSBS (e.g., checking the box to treat an LLC/partnership as a C corporation) will result in a carryover of the predecessor’s holding period in contributed property.

Failure to Qualify As QSBS If an investment fails to qualify as QSBS, the consequence is that any gain will be included upon sale. Thus, for the majority of founders and investors, the disposition of an investment that fails to qualify as QSBS will result in the inclusion of gain at the long-term capital gains rate and the imposition of net investment income tax, for a combined federal tax rate of 23.8% (under current law). Due to the entitylevel tax imposed on C corporations, however, the return achieved by an investor that 3

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expected and did not receive QSBS treatment would likely be less than the return that would have been attained had the investment been made in a flow-through entity.

Converting a Flow-Through Entity Into a Qualified Small Business Many businesses are initially formed as partnerships, S corporations or LLCs taxed as partnerships for U.S. federal income tax purposes because of the advantages of structuring businesses as flow-through entities. For instance, flow-through entities are not subject to an entity-level tax, and there is a higher likelihood that owners of flow-through entities may be able to use the business’ losses against other income during the early stages of a business’ life cycle. Due to an interest in obtaining venture financing or exiting an investment in a taxefficient manner, however, many owners consider restructuring their flow-through entities into C corporations eligible for QSBS treatment. The form and treatment of the “conversion” depends on the initial entity choice.

LLC and Partnership Conversions Process A business operating as a partnership for federal income tax purposes can easily convert into a C corporation for U.S. federal income tax purposes (as opposed to state corporate law) with a simple “check-the-box” election. By filing IRS Form 8832 to elect treatment as an “association” taxable as a corporation, a partnership – or an LLC taxed as a partnership

– will be treated as contributing its assets to a new corporation in exchange for stock of the corporation, and distributing that stock to its partners in liquidation of the partnership. That conversion is not taxable in most scenarios, and the stock that is deemed to be issued can be QSBS if the other requirements are satisfied at the time of the conversion (e.g., active business, qualified business, $50 million or less in aggregate gross assets). See “Accounting for Uncertain Income Tax Positions for Investment Funds” (Jan. 14, 2011). It is possible to significantly enhance the amount of gain that is ultimately shielded from tax if the conversion is structured correctly. That is because an investor’s exclusion from gross income can be as great as 10 times its adjusted basis, and an investor will be treated as contributing the fair market value of the partnership or LLC to the corporation in exchange for stock. Risks It is critical, however, that the conversion occur before the value of the company exceeds $50 million because property contributed to a corporation is valued at its fair market value at the time of contribution for purposes of determining whether a business is sufficiently small to issue QSBS. Further, any appreciation in the value of the partnership or LLC during the pre-conversion period will not be excludable as QSBS from gross income on the ultimate sale and instead will be taxed at applicable capital gains rates. Finally, any ownership during the preconversion period will not count toward the five-year holding period for QSBS, which will instead begin on the date of the conversion. 4

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S Corporations When a business is initially structured as an S corporation, it is also possible to transform the investment into QSBS. Although a check-thebox election will not suffice to change the business into a qualifying C corporation, the owners of an S corporation could cause the entity to contribute its assets to a newly formed or otherwise-qualifying C corporation in exchange for stock. To avoid recognizing taxable gain, the contribution of the entity’s assets to the C corporation must comply with the requirements for nontaxable corporate formations under Section 351 of the Code. Only owners of an S corporation when it acquires QSBS will be eligible to exclude gain on the S corporation’s ultimate sale of the QSBS or to receive a distribution of QSBS from the S corporation. Thus, if an S corporation is maintained and new shareholders join, the new shareholders will not be eligible to receive an excludable allocation of gain or a distribution of QSBS.

For more on S corporations in other contexts, see “PE Fund Structuring Considerations After the Final GILTI Regulations” (Sep. 17, 2019); and “Planning Strategies for Private Fund Managers Under the Tax Cuts and Jobs Act” (Jun. 7, 2018). Michael B. Gray is a partner, and head of the PE, 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 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 One workaround, however, is that new of business formations; joint ventures; investors could obtain QSBS by investing financings; equity offerings; reorganizations; directly in the newly formed C corporation subsidiary in exchange for stock. Consequently, mergers and acquisitions, dispositions; and loan workouts. He also represents business that would enable many founders and entrepreneurs to restructure their businesses entities and high net worth individuals in all phases of tax controversy matters with the IRS into Qualified Small Businesses to attract venture capital and other early stage investors, and the Illinois Department of Revenue. while enabling the founder or entrepreneur to Eric M. McLimore is a senior associate at Neal take advantage of the tax exclusion for QSBS. Gerber Eisenberg in Chicago. He advises corporations, partnerships and individuals on Similar to a conversion of a partnership or an international, federal, state and local tax LLC, any pre-contribution appreciation in the value of an S corporation will not be eligible for planning, transactional and controversy QSBS treatment, and any pre-contribution matters. He focuses on tax issues concerning income; employment; and sales and use tax ownership of an S corporation will not count issues, as well as controversies arising from toward the five-year holding period.

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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 in preparing this article.