The fragility of QSBS status and how to protect your tax benefits

Given the nature of the requirements for QSBS, most founders and early employees of traditional startups can qualify for QSBS benefits. Unfortunately, there are many ways that companies and shareholders may inadvertently invalidate their QSBS shares without realizing. Plus, maintaining corporate records and financial statements to prove eligibility can easily get lost—especially for fast-moving startups and small businesses.

This article was written in collaboration with Hanson Bridgett LLP.

What is QSBS?

Qualified small business stock (QSBS) is a tax benefit available to founders, early employees, and early investors of certain startups. The QSBS benefit allows shareholders in domestic C-corporations (C-corps) to exclude up to $10 million (or 10x their basis, whichever is higher) of gain on the sale of those shares if they hold the equity for five years.

In addition to the five year holding requirement, for stock to be QSBS-eligible, the corporation itself must meet qualified small business requirements, including:

• It generally cannot have raised more than $50 million of funding at time the shares were issued to the holder

• The corporation must not fall under certain excluded fields including health, legal, financial services, brokerage services, insurance, or banking

→ Review all of the QSB and QSBS requirements for corporations

Ju v. United States and the risks of losing QSBS status

Ju v. U.S., a recent case in the U.S. Court of Federal Claims, highlights the importance of sufficient documentation for a QSBS position. 

Background

The plaintiffs in the case, Tongzhong Ju and his wife Yanxia Li (collectively “Dr. Ju”), created a patent while employed by the University of Oklahoma. The patent was then assigned to the University and Dr. Ju was able to receive portions of any proceeds—cash and stock—based on the patent. 

The university licensed the patent to a company in 2003, which in turn issued shares to Dr. Ju as well as the university. Dr. Ju received a small portion of the shares in 2003 but received a larger portion from the university in 2015 as part of a settlement after he left the university.

Dr. Ju sold the shares in 2016 and later amended his tax return to claim a QSBS exclusion for the gain from those shares. Upon audit, Dr. Ju was unable to produce his original stock certificate for the 2003 shares he received. In addition, he was only able to produce the business’s financial records from 2009. The 2009 records show the business had less than $50 million in assets at that time (implying it met the qualified small business requirements in 2003 when he received his shares). 

Implied QSBS isn’t always enough

Ultimately, Dr. Ju was unable to retroactively prove QSBS eligibility because he did not have his share certificate and contemporaneous documentation showing his shares were issued by a qualified small business. As a result, he failed to receive the significant tax benefits. Even if you think your shares qualify for QSBS tax exclusions, the best way to prove eligibility is through timely QSBS attestation letters and documentation. Uncertainty and lack of consistent record-keeping may lead to the loss of a substantial tax benefit.

Taking the guesswork out of QSBS compliance

Founders, early employees, and venture capitalists should start documenting the QSBS status of shares they are issued as soon as possible. If your company uses Carta for QSBS Attestation, you’ll see which shares qualify for QSBS right in your dashboard. Carta shows which securities are eligible for the QSBS exclusion and whether you’ve held the shares long enough to benefit from QSBS if you were to sell the stock.

QSBS tax opinion letters

As your company grows, Carta offers essential support to help you maintain accurate records of QSBS qualification. Then, when you’re approaching an exit event, it may be helpful to have a law firm like Hanson Bridgett provide formal legal guidance—including a tax opinion letter—to support exclusions from gain for QSBS. Carta and Hanson Bridgett’s services complement each other to ensure ongoing compliance throughout your company’s lifecycle, and a smooth exit strategy when an IPO or M&A is on the horizon.

Real-time QSBS status updates

QSBS status is unique to each shareholder. Whether the company obtains an attestation letter or formal legal guidance, each shareholder must individually confirm whether their shares qualify for QSBS tax benefits. For example, one early employee can exercise her options the day before the company raises more than $50 million. Then, the day after the funding round, another employee could choose to exercise his options. Even though they received their shares just a few days apart, the first employee’s shares may be QSBS eligible, while the second employee’s are not. In addition to tracking your company’s QSBS status, Carta also monitors the shares issued to individual shareholders and employees, allowing them to access QSBS information in real time and to request a personalized QSBS attestation letter on demand.

Common QSBS mistakes that disqualify individuals and companies

A company that has not raised significant funds and is still in its early stages may not think they need QSBS attestation, but as proven in the Ju vs. U.S. case, not having this documentation early on can disqualify shares from QSBS benefits. 

Tax disqualifications

Early in the lifecycle of the company, there are a variety of ways in which a company can lose QSBS eligibility for its shares. Examples of this can include incorporation decisions, secondary transactions, using their cash for non-operating activities among other things. If the company elects to be taxed as an S-corporation (rather than a C-corporation), any shares issued to founders or early employees by the S-corp are unlikely to be eligible for QSBS. Companies should leverage Carta and their legal team to ensure they are not doing anything to unnecessarily disqualify themselves during the life of their company. 

Stock buybacks

Additionally, if a company engages in stock repurchases, such repurchases may taint the QSBS status of shares. For example, if a company raises a funding round, it may buy back the founders’ shares in order to provide liquidity to the founders. Provided the buyback is significant, it could disqualify the QSBS status of shares issued both prior to and following the buyback. So if an employee exercises options at the time of the founder buyback, they may not get QSBS for their shares, while another employee who purchased their shares before the new round was raised has their QSBS eligibility preserved.

Employee exercising and holding periods

Early employees may also lose out on QSBS without adequate planning. The QSBS exclusion benefits are only available for early employees who exercise their options and hold the resulting shares for five years. The five-year clock for QSBS exclusion benefits does not start until an employee exercises their stock options. In addition, the exercise must take place while the QSBS exclusion benefits are available (typically before the company has raised more than $50 million). Therefore, employees should carefully consider the timing of their option exercises if they hope to obtain QSBS benefits.