How to Get a Qualified Small Business Tax Exemption on a Secondary Stock Sale

The qualified small business stock (QSBS) exclusion generally provides for a full or partial exclusion of the capital gain realized on the sale of QSBS. If the conditions are met, taxpayers may exclude from gross income a capital gain equal to the greater of (i) $10 million or (ii) an annual exclusion of 10 times their base in shares sold ( for an exclusion amount up to $500 million). These limitations apply per business and per taxpayer, although there are many planning opportunities available to taxpayers, there are also many requirements that must be met in order to qualify for an exclusion under Article 1202.

Primary and secondary equity sales

Raising capital is part of the normal life cycle of a start-up business. In the simplest case, a company raises equity by issuing common stock or preferred stock directly to investors. This is sometimes called a “primary” or “initial” issue of shares. While most companies use the funds received to accelerate their growth, sometimes they use part of the funds to buy back shares from existing shareholders. For example, a company can issue convertible preferred stock to investors and buy back common stock from existing shareholders/founders. This not only provides liquidity to existing shareholders (who hold unlisted shares), but it also allows them to diversify their holdings ahead of an exit via the sale of the company or an initial public offering (IPO). This structure also works well for existing shareholders as they have the option of obtaining a QSBS exclusion.

Another popular way for companies to provide liquidity and diversification to their existing shareholders is to allow them to engage in secondary sales of stock to investors in conjunction with the company’s main stock issuance. . In secondary sales, investors buy shares from existing shareholders rather than the company itself, so the new money goes directly to the shareholders, rather than the company, and then from the company to the existing shareholders when of a buyback transaction. Although the form of these two transactions is different, they both achieve an economically similar result vis-à-vis the selling shareholders (and the tax issues discussed in this article apply to both forms of transaction).

The tax question

A tax problem may arise if the sale price received on the secondary sale is considered to exceed the fair market value (FMV) of the shares sold. This can happen, for example, if the sale price is higher than the stock’s FMV as determined in the company’s latest 409A valuation, which is a valuation that companies obtain in order to ensure that their deferred compensation programs are not subject to certain punitive tax rules. .

Consider a scenario where a company facilitates a secondary sale to new investors at $10 per share, but the company’s 409A valuation values ​​the stock at $7 per share. Can shareholders consider the additional $3 per share a capital gain that qualifies for a QSBS exclusion? In many cases, yes, but it depends on the facts and circumstances of the transaction. The Internal Revenue Service (IRS), however, could argue that the $3 per share “bonus” is a reward or benefit of the shareholders’ employment agreement with the company and therefore represents additional compensation. This argument finds support when the company has facilitated the secondary sale and may even have made it a precondition for participating in the primary sale. The IRS’ position is also stronger when the buyer in the secondary sale is a large existing shareholder, as that shareholder may be presumed to be acting on behalf of the company and may influence the sale price.

Tax issues

For selling shareholders, the tax qualification of “bonus” can mean the difference between a federal income tax rate of 37% (plus employment taxes), if considered additional compensation, and a zero tax rate if it represents a capital gain subject to a 100% QSBS exclusion. If the stock is not QSBS, the maximum tax rate would be 20% if the gain is a long-term capital gain, plus net investment income of 3.8%, if applicable. For the company, treating the bonus as compensation expense would entitle it to a tax deduction and trigger a withholding obligation. It must also accurately reflect the transaction in its audited financial statements and may be required to record a withholding tax liability.

Factors to consider in determining whether the bonus is a capital gain or compensation income

The most important fact is the FMV of the stock for the purpose of the secondary sale. If there is a “premium” that arises from a difference between the price paid by a third-party investor and the FMV in a 409A valuation, then shareholders have a strong case because third-party transactions are particularly onerous in tax law. . Shareholders also have the upper hand if the “premium” arises from the difference in price between the preferred shares sold in a primary sale and the common shares sold in a secondary sale. This is because preferred stocks often have certain conversion preferences or rights that may justify an increased valuation.

Here are some other factors that should be considered in the analysis:

1. Are the secondary sale sellers employees or independent contractors of the company? If not, that’s not a problem.

2. Is the resale open to all shareholders or only to certain employee shareholders? If open to all shareholders, did they all receive the same sale price?

3. Who sets the sale price in the secondary sale – the company or the selling shareholders?

4. Is the buyer in the secondary sale an unrelated third party or an existing shareholder? If an existing shareholder, how much of the business does the person own? Is the person a member of the board of directors? What influence did the person have in arranging the transaction? If it is an unrelated third party, is the person a strategic investor? Is there a business reason why the person would pay a premium for the stock?

5. To what extent has the company been involved in marketing or setting the terms of the secondary sale?

6. Has the company made participation in a primary sale conditional on participation in a secondary sale? If yes, why? Was the secondary sale for the benefit of the company, for example., to meet excess demand for shares or to avoid dilution, or was it in the interests of shareholders? What was the intention of the parties?

7. Was the secondary sale a single transaction or one in a series where the company helps create a market for the stock?

8. How did the parties report the transaction for tax and financial statement purposes? Note that most companies treat the bonus as a compensation expense under generally accepted accounting principles (GAAP), but reporting for financial statement purposes does not control for tax purposes.

While no single factor is determinative, considering all factors can help parties get the most out of the tax analysis one way or the other. The issue is important for shareholders because it directly affects the amount of tax they pay. For businesses, there are a variety of reasons why they need to flesh out the facts to support their position, both for tax purposes and for financial statement purposes. Companies should also expect their external auditors to raise this issue, and thorough documentation (which may include a memorandum analyzing the facts) often wins out. Going forward, companies should consider the impact that the sale price during the secondary sale is likely to have on the value of its shares during the next 409A valuation.

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