Business Vantage Point Blog

“Look on every exit as being an entrance somewhere else.” – Sir Tom Stoppard, playwright and screenwriter

Particularly since tax rates for C corporations were decreased to 21% starting in 2018, we have seen startups begin their life as C corporations for federal income tax purposes rather than waiting to convert upon future growth. In addition to positioning the startup for an eventual venture capital funding round, C corporation status also starts the five-year holding period for the QSBS (qualified small business stock) tax break.

In a prior post, we discussed some of the basics of the QSBS tax break. This post focuses on some considerations as a QSBS investment matures and a liquidity event is in sight.

Moving Toward an Exit: Considerations

Rollover Under Section 1045. In general, Section 1045 of the Internal Revenue Code allows some or all of the amounts received that are subject to capital gain in a QSBS investment to be invested into a second QSBS investment, thus preserving QSBS benefits via a second investment. Importantly, Section 1045 allows QSBS investments that have not been held for five years (but have been held for at least six months) to maintain their QSBS status through a rollover investment; i.e., if there is an exit event before five years, the QSBS holder can still potentially take advantage of the QSBS tax break, although via a second QSBS investment.

Among other limitations, a key practical limitation to utilization of Section 1045 rollovers is that the second QSBS investment needs to be acquired within 60 days of the sale of the first QSBS investment. Oftentimes owners, particularly those busy with closing and post-closing transition issues, don’t have the time or information at hand to line up a second QSBS investment that is worthy of receiving the owners’ hard-earned deal proceeds. Just as with the original QSBS investment, the second “rollover” QSBS investment should be vetted for QSBS qualification. Ideally the second company (the one issuing “rollover” shares) would provide representations on QSBS status, covenants to report consistently therewith and provide necessary documentation, and an indemnification if representations or covenants are breached.

We have fielded questions about whether a “rollover” QSBS investment meets the active business requirement for QSBS treatment. Starting in 2024, the IRS stated it will no longer issue private letter rulings on the active business requirement (see Revenue Procedures 2024-3 and 2025-3), indicating the question could be under study by the IRS, with possible guidance forthcoming. We are continuing to monitor for developments.

Planning for the five-year holding period. Sometimes sellers who have owned stock for less than five years have a buyer willing to enter into an agreement to acquire the QSBS stock for legal purposes after the five-year holding period has been met. It is certainly possible to agree to a sale before the five-year holding period is met and close on the sale after that holding period is met, but meaningful planning would be needed to avoid having the sale treated as a constructive sale for tax purposes on an earlier date (thus depriving QSBS benefits).

SAFEs. While not a focus of this post, there is substantial uncertainty whether a simple agreement for future equity (SAFE), even if the SAFE has language stating equity ownership is intended upon issuance of the SAFE, is equity for QSBS treatment.

Gifting pre-sale. The closer to an exit, the less value there would generally be in gifting QSBS stock. However, “stacking” gifts could still be beneficial. (View this article for more.)

QSBS attestation letter. Obtaining a QSBS attestation letter from the company that issued QSBS shares helps strengthen the case for the QSBS tax break upon an examination by a taxing authority. Obtaining a letter is a reasonable ask as part of any consent to a sale. Please note that while we view the request as reasonable given that the company has all the requisite information, some companies refuse to issue such a letter.

Lack of state conformity. Not all states conform with federal law on QSBS, thus causing state income taxes to be occasionally due when no federal income tax is due. This can surprise unprepared taxpayers.

Election on income tax return. Both the QSBS exclusion and the rollover under Section 1045 need to be affirmatively opted into on tax returns.

Multiple blocks. The sale documents should specify which blocks of stock are sold — particularly if some blocks qualify for QSBS treatment and others do not. (For example, if those blocks were purchased within five years of the sale or were purchased when the company was no longer a qualified small business under IRC Section 1202.)

Finishing the Exercise

The QSBS tax break can be lucrative for founders and early investors and help attract investors during the early life of a startup. As the life cycle of the startup moves toward an exit (and a “somewhere else”), finishing the exercise and ensuring the tax break is able to be utilized is an important component of the exit.