The qualified small business stock (QSBS) exclusion generally provides for a full or partial exclusion of capital gain realized on the sale of QSBS. If the requirements are met, then taxpayers can exclude from gross income capital gain in an amount equal to the greater of (i) $10 million or (ii) an annual exclusion of 10 times their basis in the stock sold (for an exclusion amount up to $500 million). These limitations apply on a per-company and per-taxpayer basis, while 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 section 1202.
Primary and Secondary Sales of Stock
Raising capital is a normal part of the lifecycle of a start-up business. In the simplest case, a company raises equity capital by issuing common stock or preferred stock directly to investors. This is sometimes called a “primary” or “original” issuance of stock. While most companies use the funds received to accelerate their growth, sometimes they use part of the funds to redeem stock from existing shareholders. For example, a company may issue convertible preferred stock to investors and redeem common stock from existing shareholders/founders. This not only provides liquidity to existing shareholders (who hold non-publicly traded stock), but it also allows them to diversify their holdings before an exit via sale of the company or initial public offering (IPO). This structure also works well for existing shareholders because they have an opportunity to obtain a QSBS exclusion.
Another popular way for companies to provide liquidity and diversification for its existing shareholders is to allow them to engage in secondary sales of stock to investors in conjunction with the company’s primary issuance of stock. In secondary sales, investors purchase stock from existing shareholders rather than from the company itself, so the new funds flow directly to the shareholders, rather than to the company and then from the company to the existing shareholders in a redemption transaction. While 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 the transaction).
The Tax Issue
A tax issue can arise if the sale price received in the secondary sale is considered greater than the fair market value (FMV) of the stock sold. This can arise, for example, if the sale price is greater than the FMV of the stock as determined in the company’s latest 409A valuation, which is a valuation companies obtain for purposes of ensuring 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 the shareholders take the position that the extra $3 per share is 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 “premium” is a reward or benefit of the shareholders’ employment arrangement with the company and thus represents additional compensation. This argument finds support when the company facilitated the secondary sale and may even have made it a condition precedent for participation in the primary sale. The IRS’s position is also stronger when the purchaser in the secondary sale is a large, existing shareholder because that shareholder can be presumed to be acting on behalf of the company and can influence the sale price.
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The Tax Stakes
For selling shareholders, the tax characterization of the “premium” can mean the difference between a 37% federal income tax rate (plus employment taxes), if it is viewed as additional compensation, and a zero tax rate if it represents capital gain subject to a 100% QSBS exclusion. If the stock is not QSBS, then the maximum tax rate would be 20% if the gain is long-term capital gain, plus the 3.8% net investment income if applicable. For the company, treatment of the premium as compensation expense would entitle it to a tax deduction and trigger a withholding obligation. It also needs to accurately reflect the transaction in its audited financial statements and could be required to record a payroll withholding liability.
Factors to Consider in Determining Whether the Premium is Capital Gain or Compensation Income
The most important fact is the FMV of the stock for purposes of the secondary sale. If there is a “premium” that derives from a difference between the price paid by a third-party investor versus the FMV in a 409A valuation, then shareholders have a strong case because third-party transactions are particularly compelling in the tax law. Shareholders also have the upper hand if the “premium” derives from the difference in price between preferred stock sold in a primary sale versus common stock sold in a secondary sale. This is because preferred stock often has certain preferences or conversion rights that may justify an increased valuation.
Below are some other factors that should be considered in the analysis:
1. Are the sellers in the secondary sale employees or independent contractors of the company? If not, then this is not an issue.
2. Is the secondary sale 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 set the sale price in the secondary sale – the company or the selling shareholders?
4. Is the purchaser in the secondary sale an unrelated third party, or an existing shareholder? If an existing shareholder, how much of the company does the person own? Is the person a board member? How much influence did the person have in arranging the transaction? If 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. How involved was the company in marketing or setting the terms for the secondary sale?
6. Did the company condition participation in a primary sale on participation in the secondary sale? If so, why? Was the secondary sale for the benefit of the company, e.g., to fulfill excess demand for the stock or to avoid dilution, or was it for the benefit of the shareholders? What was the intent of the parties?
7. Was the secondary sale a one-off transaction, or one in a series of transactions where the company is helping create a market for the stock?
8. How did the parties report the transaction for tax purposes and for financial statement purposes? Note that most companies treat the premium as compensation expense under generally accepted accounting principles (GAAP), but reporting for financial statement purposes is not controlling for tax purposes.
While no single factor is dispositive, consideration of all the factors can help the parties bottom out the tax analysis one way or the other. The issue is important to shareholders because it directly affects the amount of tax they pay. For companies, there are various reasons why they need to flesh out the facts to support their position, both for tax purposes and for financial statement purposes. Companies also should expect their external auditors to raise this issue, and thorough documentation (which may include a memorandum analyzing the facts) often carries the day. Looking forward, companies should consider the impact the sale price in the secondary sale is likely to have on its stock value in the next 409A valuation.