EP 60: The Tax Benefits Most Venture Investors Aren’t Aware Of
February 4, 2020 | Scott Murphy
Federal Tax Exclusions and Qualified Small Business Stock
Most venture investors are aware that deploying capital in early-stage, high-growth companies provides the opportunity to earn high-value returns. However, investors might not know they can claim a federal tax exclusion by investing in Qualified Small Business Stock. Essentially, if the stock meets six requirements laid out by the Internal Revenue Service, an investor does not have to pay taxes on gains of up to $10M or 10x the adjusted basis of the stock, whichever is greater.
To answer some common tax questions from potential Alumni Ventures Group investors, we sat down with Strawberry Creek Ventures Managing Partner Peter Loukianoff, who leads AVG’s fund for UC Berkeley alumni and friends. Peter is joined by Andrea Kushner, Senior Vice President and Director of the Wealth Strategies Group at Alliance Bernstein. Andrea is also a member of the State Bar of California, by which she’s been certified as a specialist in taxation law, estate planning, trust, and probate law.
Together, they explain how venture capital investors can gain even more from investing in small or early-stage businesses. Below is a transcript of their conversation, edited for readability and clarity.
Disclaimer: This is not a solicitation to sell securities, which is only done through appropriate disclosure documents and only to appropriately qualified investors.
Will you explain why this topic important?
Peter Loukianoff: I’ve spoken to a lot of investors over the past few years, and they really come to the realization that access to entrepreneurial startup companies in a fund format should be an important part of their overall portfolio mix. But on top of that, there’s a tax benefit that most people are actually not aware of, called the QSBS exclusion. Investors really need to know about that. If they’re not investing in venture capital in this way, not only are they missing out on essential appreciation in the private market, but they’re also missing out on some significant tax breaks.
What can you tell us about the QSBS exclusion?
Andrea Kushner: QSBS stands for the “Qualified Small Business Stock.” It’s an exclusion that’s set forth in the internal revenue code, and it’s actually not new. It’s been on the books since 1993, and it was implemented to encourage investment in emerging businesses by founders, employees, and investors.
What questions do potential investors have about QSBS?
Peter: Most investors do not know that it exists, and I think they find it surprising that it’s available. Obviously they’d love to take advantage of it, because having an opportunity to have a tax exemption on up to $10 million of capital gains is a very nice benefit for folks.
What are the requirements for stock to be considered QSBS?
Andrea: For the qualified small business stock exclusion, there’s six requirements. The first is that the tax payer has to own C corporation stock, and it has to be what’s called “original issue” in stock. In other words, it has to have been issued directly from the corporation to the tax payer. And the tax payer can either be an individual or it can be a partnership. Many venture funds qualify as an eligible tax payer because those benefits flow down to each individual investor. S corporations qualify too.
The C corporation that’s issuing the stock has to be small at the time that the stock is issued. It has to have $50 million or fewer in assets at the time that stock is issued. At least 80% of the assets of the C corporation have to be used in an active trade or business. The C corporation also has to be involved in a qualified business. That’s defined in the negative in Section 1202. There’s a list of the things that don’t qualify. We sometimes refer to them as the naughty list in my office. But they’re a service business, primarily. Financial services, law firms, accounting, restaurants, things in hospitality don’t qualify. Things that do qualify are manufacturing and technology.
There’s a holding period requirement. The stock has to be held for at least five years by the tax payer to take advantage of the exclusion on an exit. And the final requirement is that the business has to fulfill the act of business requirement and is a C corporation during substantially all of the tax payer’s holding period.
Is AVG specifically going after stocks that will qualify for this or it just is a benefit if it happens to?
Peter: Our main objective is to provide access to quality investments, diversified by geography, sector, and stage. We do not optimize per se on specific companies, because our key thing is to create this broad portfolio.
However, having said that, as we put the portfolio together, there will be companies that qualify and others that won’t. Most of the companies will certainly qualify under the $50-million-or-less-in-assets test. The rest of it plays out as we go, but it makes sense for us to diversify by geography, sector, and stage. So, we do roughly have an equal distribution of early-, mid-, and late-stage investments. The late stage investing may not qualify under that part of it, but the early-stage companies will likely qualify. Most mid-stage companies will qualify as well. So, it’s a reasonable expectation that many — if not most — of our companies will qualify under QSBS and that our investors will get this benefit.
One of the requirements of QSBS is that you have to hold the stock for five years. And with venture capital, you don’t always have control over that. Could you help us understand what happens if there’s an earlier exit?
Andrea: If a tax payer has held the stock for at least six months and the company fulfills all the other requirements, but we are just short of the holding period, there’s an opportunity that’s provided in another code section. It’s Section 1045 that says, on an exit, if you take your proceeds and you invest in another qualified small business, on that second exit, you can take advantage of the small business stock exclusion as long as the total time that you’ve owned both the first stock and the second equals five years.
For example, let’s say I had invested in a company, we had an amazing liquidity event, and we got this great unsolicited offer, but it came after I had owned the stock for three years instead of five. If I take my proceeds from that sale and invest in a second qualified small business, as long as I hold that stock for another two years, I will have met the five-year holding requirement, and I can take advantage on the exclusion on the second exit.
In a fund setting though, it sounds like you would not necessarily be able to automatically reinvest in a fund because not every stock held in it would be QSBS. Can you explain what a syndicate deal is and how it differs from typical AVG funds?
Peter: These are direct investments by our investors interested in a specific company. It’s outside of the fund, but as an investor to the fund, if they’ve met certain criteria, they get a chance to invest in these syndicate deals, where they would be able to invest directly into the company through us.
Andrea: If the syndicate is itself a qualified business, it would qualify. As long as it’s a C corporation, it has less than $50 million in assets, 80% of the assets are used in an active trade or business, and it’s a qualified business, then that reinvestment qualify.
It sounds like there are some nuances to the QSBS exclusion. I like that the 1045 exchange gives you a plan B for avoiding taxes if you are luckily enough to have a fast and lucrative exit, but I’d want to make double sure that that second investment still qualified.
Andrea: Let me make it clear that we’re not providing tax or legal advice in this podcast. We’re providing information and education so that the listeners are more informed about the qualified small business stock exclusion and when it can be helpful. But anyone listening who is thinking about using the exclusion, has an exit in the near term, and is wondering whether it could be helpful, in those cases, it’s critical to obtain qualified tax and legal counsel.
We’ve gathered up some of the more common tax-related questions that potential AVG investors have asked. What is the next question with regards to the QSBS exclusion?
Peter: A question comes up about whether QSBS applies to retirement accounts.
Andrea: Not really. Bear in mind that when a sale happens in a traditional IRA, that’s tax exempt. In other words, there’s no tax that’s generated at the time. When a tax payer pays taxes when they take distributions out of the IRA and they’re taxed, it is taxed as ordinary income. So, it really wouldn’t be beneficial to own qualified small business stock in an IRA per se if the idea is to use that exclusion to avoid tax. It would be better sourced in a taxable account.
Would you provide some specific examples where somebody invested early and was able to take advantage of this exclusion?
Andrea: There are some significant now publicly-traded companies that the initial issuance of stock from those companies qualify as qualified small business stock, like early investors in Facebook. Stitch Fix is another one where people tend to forget about since they’re mega companies now. Stock issued by those companies today would not qualify, but anything that was issued in the early days would.
It’s important to be mindful of that when you’ve got multiple rounds of funding and capital raises, because it could be that after round A and B when stock that was issued, the company was still at $50 million or under. So that stock would qualify. But once round C came in, the asset value went over $50 million, and now stock issued by that company isn’t going to be qualified small business stock anymore.
So people who got in early got the benefit of this exemption?
Is QSBS a major selling point or the a cherry on top?
Peter: It’s a cherry on top. People don’t know that this exists, and they’re investing because they want to get access to venture capital and do it in a very smart and easy way. That’s why they invest with us. QSBS is an added benefit, but it’s not the reason we do it. But it’s certainly something they should know about.
What is something else that potential investors should understand about this?
Peter: Private companies today are staying private longer. Going back to the 1980s/1990s time period, companies would go public, and then they would go public at valuations that are a couple hundred million dollars. And an investor, who’s a public market investor and didn’t have any private access, could actually do quite well in the public market and be able to invest in companies like Apple and Microsoft and so forth. Back then, they could get in at reasonable valuation and ride the stock up to pretty significant valuation.
Today, the entire market is upside down. Private companies are staying private longer. As a result of that, what’s happening is that when companies go public, they’re not going public at a couple million dollar valuations. They’re now going public at multi-billion dollar valuations. So when the public market investors get involved in these companies, they’re already paying a much higher price, and they lost out on that capital appreciation that happened in the private realm.
Are there any other tax benefits that come with investing in venture capital?
Andrea: My clients tend to like investing in venture, especially through a fund, for some of the reasons that Peter talked about. You get the opportunity to invest by doing it through a fund, you get a diversified portfolio of different investments and a mix. So you get the exposure, but it reduces your risk to a degree. You also get the benefit of “pass-through treatment” as an investor. Meaning, you’re investing together, so for all the distributions, you pay tax on your distributive share, and there are tax planning opportunities around that. But I think there’s more just from an investment perspective why it can be really interactive.
Any last thoughts about this topic or venture capital in general?
Peter: Regardless of the tax implications, access to venture capital is still super important for individuals because. As we mentioned earlier, private companies are staying private longer, and there’s a lot of value being created in that realm. Getting access to that and taking advantage of that is very important. Large institutional investors have been taking advantages of this for a long time.
One of the reasons why AVG exists is to democratize venture capital for the individual investor, but doing it in the right way in terms of getting access to quality deals, diversifying properly across geography, sector, and stage. This is something that an individual really cannot get access to normally, and that is what we provide at Alumni Ventures Group and Strawberry Creek Ventures.
Andrea: I would say two things. One, Section 1202, it’s a federal benefit for excluding federal taxes. Some states follow it as well, so it’s important for anyone listening to check their state requirements or with their tax advisors. I’m in California and, sadly, California doesn’t follow it, but other high-tax states, like New York, do. So it’s important because in some cases, it can be a state as well as a federal benefit.
The other thing I would stress is that it’s important to follow all of the requirements for qualification. So, again, I want to reiterate that it’s really important to have good tax and legal advisors to help you navigate the qualifications.
About Peter Loukianoff
Peter Loukianoff has 20+ years of experience as a business innovator, leader, and investor in Silicon Valley, Europe, and Asia. He is a member of the Forbes Global CEO network; has served on numerous boards and done business in 40+ countries. He was Senior Advisor at McKinsey & Co., a Co-founder and seed investor of Silicon Valley Data Science, Co-founder and Managing Partner of Almaz Capital, and a partner at Alloy Ventures. Previously, he was a founding member and operating executive with several startups. Peter is a co-inventor of several patented mobile messaging technologies and earned an MBA and BS in Engineering from UC Berkeley. Notable Deals: Yandex (IPO), Xactly (IPO), Qik (acq. by Skype) and Silicon Valley Data Science (acq. by Apple).
About Andrea Kushner
Andrea Kushner (Andi) is a Senior Vice President and Director of the Wealth Strategies Group at Alliance Bernstein. She works with Bernstein clients and their professional advisors to develop comprehensive wealth management and wealth transfer strategies. Before joining the firm in 2015, Andi was a shareholder at Weinstock Manion, ALC, and a partner at Karlin & Peebles LLP, advising high-net-worth clients on estate, tax and charitable planning. She is a member of the State Bar of California, by which she has been certified as a specialist in both taxation law and estate planning, trust and probate law. Andi was named a Southern California Rising Star and a Super Lawyer by Super Lawyers Magazine. She currently serves on the executive committee (trusts and estates section) of the Beverly Hills Bar Association and is a member of both the taxation and trusts and estates sections of the Los Angeles County Bar Association. She has also served on the executive committee (taxation section) of the State Bar of California and was a former chair of the taxation section of the Beverly Hills Bar Association. Andi holds a BA (cum laude) in political science from the University of California at Los Angeles; a JD from the University of Southern California at Los Angeles; and an LLM in taxation law from Loyola Law School of Los Angeles.