Startup Investing Mistakes That Could Kill Your Section 1202 Tax-Free Gains
Updated: Jun 8, 2020
By: Tom Lazay with Scott Pinarchick
Investors who think they’ll save millions in capital gains taxes through Section 1202 of the IRS Code (Small Business Qualified Stock) might not actually qualify for this benefit depending on how they make the investment and other circumstances that occur prior to an exit.
In the course of my fundraising discussions with angels, VCs, and family offices, I’ve been quite surprised at how many sophisticated investors are either unaware of the tax-free opportunities provided by Section 1202 or confused about the specific IRS rules.
Since I couldn’t find clear guidance on some areas of Section 1202, particularly surrounding investments in venture capital funds, convertible notes, and SAFEs, I sat down with Scott Pinarchick, a partner at Mintz in Boston who specializes in Tax and Private Equity. Scott has been practicing law for 22 years in Boston and Mintz has a strong corporate practice working with startups, VCs, and private equity firms, both on the buy and sell-side, while also maintaining a strong capital markets practice.
Angel investors and fund managers often tout the tax advantages of early-stage investing through Section 1202 of the IRS Code (Small Business Qualified Stock), which was enacted in 1993 to incentivize small business growth. As explained here, if an investment qualifies for 1202 treatment and successfully exits, its investors can avoid up to 100% of the capital gains tax on the greater of $10M or 10x their cost basis. In the case of a venture capital fund investor (known as a Limited Partner or LP), the exclusion operates on a per-LP and per-company profit distribution basis.
While not a comprehensive list, the most-relevant 1202 qualifying criteria for most early stage-tech investments are:
The stock was issued by a domestic C-corporation. An investment made in an LLC does not qualify.
On the date of the stock issue and immediately after, the aggregate gross assets of the issuing corporation did not exceed $50 million. Investors should be mindful of the company’s post-money valuation.
The issuing corporation does not purchase any of the stock from the taxpayer during a four-year period beginning two years before the issue date. However, there are some very limited exceptions to these rules.
The stock is held for at least 5 years.
The corporation uses its assets in an active qualified business.
Investments in Venture Funds and circumstances around the start of the 5-year holding period seem to cause the most confusion, especially when investments are made as convertible notes or SAFEs. To clear up the confusion, I asked Scott some questions I had about Section 1202 of the IRS Code.
Venture Fund Investments
Many investors assume Section 1202 tax benefits are only available to angels who make direct investments in startups. Do the benefits extend to limited partners (LPs) in a venture fund?
Most venture funds are structured as limited partnerships which are pass-through entities. Fund LPs who are US taxable individuals should receive the benefit of Section 1202 directly when their venture fund makes an exit from a QSBS investment so long as they are LPs when the fund makes and exits the investment (at least five years later).
Given that many early-stage funds have multiple closings over a 1-2 year period, does it matter when an LP invests in a fund to get the benefit of Section 1202 tax treatment on distributions?
An exit by a fund of a QSBS investment will only have Section 1202 tax treatment for LPs who were investors in the fund at the time that the investment was made. LPs who invested in the fund after the fund’s investment was made in the QSBS investment will pay full capital gains from that particular exit.
In my conversations with potential LPs, many have asked me whether several individuals can pool their capital into an LLC to make a fund investment. Does 1202 tax treatment extend to pass-through entities that invest in a fund?
Individuals who pool capital into a US S Corporation, LLC or trust, partnership, or common trust fund that becomes a partner in the fund should still receive the benefit from Section 1202 as long as it is a flow-through entity and the gain flows up to a US taxable individual.
A common strategy for VC fund managers is to make one or more company investments prior to their fund’s first close. General managers either make direct investments using personal funds or create a Special Purpose Vehicle (SPV). Once the VC fund has its first close, these early investments are then transferred into the new fund. Investors call this process “deal warehousing." Does deal warehousing impact the benefit of Section 1202 for all Limited Partners?
Transferring an investment or contributing shares to a partnership generally nullifies the qualified small business stock treatment for all parties involved. If fund managers are trying to maximize the tax benefits for their LPs, they should try to avoid warehousing and invest directly from a closed or fertile fund. Pooling the initial investors’ funds into a first “soft” close of the VC fund and making the investment from the fund is a much better way to benefit from Section 1202.
While many investors buy equity in an early-stage company, others use different instruments such as convertible notes that can eventually transfer into equity. While some convertible notes convert at a near-term round of financing, others can take years to convert if the startup delays the round or exits before the conversion. For more clarity, does the signing date of the convertible note start the 5-year holding period to qualify for 1202 treatment?
No, the convertible note execution is not the start of the holding period for qualified small business stock because a convertible debt instrument is not considered equity. Investors must convert the note into equity to start the five-year holding period (assuming the company stock meets the 1202 requirements at the time of the conversion).
If investors suspect that a convertible note’s lifetime could be a year or longer, they might consider negotiating a priced round with the entrepreneur instead of using a debt instrument given the potential high opportunity cost of negating tax benefits.
Some startups execute SAFEs (Simple Agreement for Future Equity) as a substitute for an equity round. Other startups use SAFEs as a bridge mechanism while they fundraise or complete a diligence process with a prospective investor. Does the 5-year holding period for 1202 treatment start when a SAFE investment is executed or when it actually converts into equity?
Whether a SAFE investment qualifies for 1202 treatment is unclear and really depends on the terms of the SAFE. While a SAFE is generally not considered debt, it can be perceived differently by the tax authorities depending on its terms.
On one hand, a SAFE can be interpreted as a prepaid forward contract for investors to attain new stock when it’s issued. In this scenario, a SAFE is not considered equity and an investor is not treated as an owner until this new stock is issued. On the other hand, a SAFE can be interpreted as current equity even though it technically becomes a different class of equity in the future. In this case, the five-year holding period begins at the issue of the SAFE.
Given this gray area around 1202 treatment for SAFEs, investors should tread carefully and seek the advice of their tax advisors when classifying SAFE investments.
Mergers, Acquisitions, and Recapitalizations
Do cashless transactions such as mergers, acquisitions, and other recapitalizations eliminate the benefits of Section 1202?
While these exchanges don’t eliminate the benefit of Section 1202, they can limit the benefit since they’re usually treated as an exchange of the stock and therefore investors are legally obligated to test whether their new stock is treated as qualified small business stock. If the new stock qualifies as 1202 stock, the benefits continue. If the new stock does not qualify, the 1202 benefits become limited to the value of stock on the date of the exchange; value increases after this date are then subject to regular tax.
Companyon Ventures funds B2B software startups into their expansion-stage by injecting decades of startup and VC experience through operational hands-on investing. The Boston-based firm leads post-seed, pre-expansion rounds in capital-efficient startups across North America that are ready to scale. Companyon’s capital and expertise help scale portfolio companies into a supersized Series A or non-dilutive growth. The firm invests in startups with $1-3M in recurring revenue aiming to scale by 2-3x in the first year with help from its growth-ops Platform Team that offers experience, tools, and playbooks used in top-performing software startups.
Mintz is a versatile Am Law 100 law firm with 500+ attorneys serving technology-focused clients worldwide. With extensive experience in fintech, information technology and outsourcing, AI and robotics, digital and social media and a rapidly growing paytech practice encompassing e-commerce, payment technology and other areas of financial technology, Mintz advises investors, innovators, and business leaders on pivotal deals, disputes, and regulatory matters. Mintz’s practitioners have navigated every legal or business challenge, meeting clients' needs across all of its offices in New York, Boston, Los Angeles, San Diego, San Francisco, Washington, DC, and London.