What Happens When QSBS Doesn’t Go As Planned
Updated: Sep 8, 2020
The upside of Qualified Small Business Stock (QSBS) is very attractive to investors and business owners alike, as we have explored in recent posts. As we discussed last week, businesses need to make sure they follow the correct steps, starting early on. Another important topic is that there are also some gray areas that can play out in interesting ways, and that is what we are addressing in this post. Our QSBS experts, who recently partook in Aumni's webinar on the subject, covered some ground as to these gray areas that have the potential to go wrong.
What happens when partners don’t agree.
First of all, there are times where there can be different interpretations, and stakeholders may not see a situation the same way. For example, let's look into disqualification risks, or just getting to the point where you could even claim investments as qualified small business stock. Ryan Gaglio, Attorney and Shareholder with Stradling Law, had this to say:
Depending on the circumstances, which side of the argument you want to be on may be very different. From a founder or an investor perspective, you're typically looking to take the position that is qualified small business stock. You invested money, you got back this equity-like instrument, and typically you want that to start your holding period. So, very often the push there is to take the position that the safe effectively is common stock, at least for income tax purposes, for this reason. And I think there are lots of good reasons to view a safe in that way, given that it really does look a lot like being long in the common stock.
With the decision left to the tax filers as to how to define their position, can an issue emerge back at the fund level if those individual tax advisors for the partners take different stances on whether or not it should qualify as QSBS? For example, if the corporation whose stock was sold has represented that they do meet the eligibility requirements for the classification of QSBS and but it's not independently verified, the partners still have to consult with their own tax advisors on what they should be doing. Andersen's Lindsay Chamings thinks that it depends:
There are some stances specifically related to carried interest that different tax partners might have a different take on, so I can see that. [However,] I don't think it could have an implication at the fund level itself. If you draft your footnote [with] enough caveats around what you do know and what you don't know, I don't think it would have an impact on the fund or the positions people are taking. So, I don't think that would be an issue because the fund itself doesn't take a stance really.
Where QSBS can go sideways or out of line with expectations.
There are also times when a business doesn't stay the course that was initially planned. Say you took a position, particularly if it was one that was questionable or unclear, should you be conservative and keep funds available to potentially cover any liability if the IRS doesn’t agree with your determinations? We asked the group for any specific war stories where the IRS disagreed or have gotten in an audit situation where this became a contentious issue. Stradling Law's Ryan Gaglio noted:
I would say where the more interesting discussions take place are in circumstances where the company has made representations about qualified small business stock along the way. Sometimes those representations don't always take the same form. In the current NVCA documentation there is a specific representation about qualified small business stock and it's drafted in a pretty precise way. It clearly gets certain factual elements, and it usually disclaims it being subject to indemnification. The idea being: it's really more of an informational type of representation. Sometimes they have a little bit more of an indemnification type flavor.
Where I have seen a little bit more of an interesting instance [is where] the business has progressed: maybe someone starts to either think it doesn't qualify for qualified small business stock anymore, or the facts have changed. Maybe it's moved in a little bit more of a services direction, and maybe people start to question whether or not it qualifies. And that actually creates a really interesting dynamic at the board level where you have certain investors, maybe earlier investors who have more at stake than later investors or new investors. I have seen some interesting board level discussions where certain constituencies in the board are very confident or feel very strongly about what qualifies as a small business stock, certain constituencies have a different view, and where you layer on to that, the potential for a claim. If the company were to have actually breached a representation, really how would that loss be made up? It really wouldn't be a certain subset of investors subsidizing other investors. And so those dynamics can be really interesting over the life cycle of the company where you have some venture capital funds [who] really value it. You may have other investors who are foreign investors who may not care at all.
So, that's a more interesting dynamic. I can't say I've seen a company reserving for it, but you can sort of imagine a discussion, especially in connection with a sale where a buyer might say, "I don't want to mess around with you guys suing each other about qualified small business stock and special indemnity."
QSBS gray areas should be thought through. Understanding where the lines may blur can save you from some sticky situations later on if different parties have claimed the investment in different ways, or in general, if things change. Aumni has designed an interactive tool that helps identify whether your investment meets the QSBS criteria, which may be a helpful start.