Current Issues for Qualified Small Business Stock — How New R&E Expensing Rules Could Hurt Your QSBS Status, and Why Cash Management Changes Likely Won’t

Background 

An early-stage company can offer prospective investors an attractive investment opportunity, particularly if the company’s stock will qualify as “qualified small business stock” (QSBS) for US federal income tax purposes. This is because noncorporate investors in QSBS may be able to exclude from their federal gross income all or a portion of the gain recognized when they sell QSBS after a five-year holding period. There are many requirements (both at the shareholder level and at the corporate level) that must be satisfied for a company’s stock to qualify as QSBS and produce eligible gain exempt from federal income tax. Among others, these requirements include (i) that the issuing corporation’s gross assets may not exceed $50 million at any time prior to and immediately after the stock issuance (the Gross Asset Test), and (ii) that at least 80% of the issuing corporation’s assets (measured by value) are used in one or more qualified trades or businesses during substantially all of the investor’s holding period for the stock (the Active Business Test). 

This alert discusses only selected issues with respect to the Gross Asset Test and Active Business Test. For an in-depth discussion of QSBS or questions regarding any particular QSBS issue, please contact a member of Goodwin’s tax department. 

R&E Expenses and Tax Basis Tracking 

Under the Gross Asset Test, newly issued stock will qualify as QSBS only if the amount of cash plus the aggregate adjusted tax bases of all other properties held by the issuing corporation does not exceed $50 million at any time prior to and immediately after the stock issuance (taking into account amounts received by the corporation in the issuance). Under the law in force prior to the changes discussed below, technology and other early-stage companies operating in research-intensive industries could often (in large part) look at the amount of cash and receivables on their balance sheets as a reasonable proxy for determining compliance with the $50 million threshold, because any noncash assets typically were held with low or no tax basis. 

For tax years beginning after December 31, 2021, Section 174 of the Internal Revenue Code of 1986, as amended (the Code), provides that expenses incurred in connection with research and development activities, including all costs incident to the development or improvement of a product (collectively, R&E expenses), are no longer immediately deductible. Instead, R&E expenses must be capitalized and amortized ratably over a five-year period (or 15 years if such expenditures are attributable to research conducted outside of the United States). As a result, technology and other early-stage companies that incur significant R&E expenses will generally accumulate tax basis in their assets as research and development costs are incurred. This could cause such companies to approach the $50 million threshold much faster than expected. 

Practitioners anticipated that Congress would repeal the changes to Section 174 of the Code and reinstate the deductibility of R&E expenses under prior law, and several bills have been introduced in Congress to effect such a change, but nothing has changed yet as of this alert. Accordingly, technology and other early-stage companies that intend to issue QSBS in one or more upcoming financings should pay close attention to the impact of the new rules on their assessment of the $50 million requirement, and companies that have issued stock intended to be treated as QSBS since December 31, 2021, may need to revisit their compliance with the requirement. 

Cash Management Strategies and the Active Business Test

Under the Active Business Test, at least 80% of the value of the corporation’s assets must be used in the active conduct of one or more qualified trades or businesses for substantially all of the investor’s holding period for QSBS. A corporation automatically fails the Active Business Test for any period if more than 10% of the value of its net assets consists of stock and securities of other corporations that are not subsidiaries (the Securities Test). A corporation is considered a subsidiary if the QSBS issuer owns more than 50% of such corporation by vote or value. However, cash and other passive investment assets (including stock and securities of other corporations that are not subsidiaries) are considered to be used in an active business, subject to certain limitations, to the extent they are held to meet the corporation’s reasonable working capital needs or are held for investment and reasonably expected to be used in a qualified active business within two years (the Working Capital Exception). Under the Working Capital Exception, beginning two years after the corporation is formed, no more than 50% of the value of the corporation’s assets can qualify as used in the active conduct of a trade or business by reason of being working capital or investment assets. 

In the wake of recent high-profile bank failures, many QSBS issuers have implemented strategies designed to protect their cash from systemic risk in the banking sector. In some cases, companies have begun investing cash in money market funds, mutual funds, and other marketable securities that can easily be converted to cash. Such practices have led a number of QSBS issuers to worry that such investments could cause a Securities Test failure. While that could be a possibility in certain circumstances, it will not be an issue for most early-stage companies because the Working Capital Exception still applies.

If cash that is otherwise held for the reasonable working capital needs of a business is invested in liquid securities, money market funds, or accounts to hedge a corporation’s bank risk, these securities and accounts should continue to be treated as assets held for use in an active business for QSBS purposes under the Working Capital Exception. In other words, the Working Capital Exception, which is more generous than the Securities Test, overrides the Securities Test with respect to assets that are held for the reasonable working capital needs of the business. In addition, both the 50% limitation of the Working Capital Exception and the 10% Securities Test are measured against the fair market value of a corporation’s assets and not against tax basis or book value. Although corporations intending for their stock to qualify as QSBS should always monitor and properly account for short-term investment holdings held as working capital assets, in practice we would not expect that many such companies would have complications under the Active Business Test as a result of managing cash through less traditional means.