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QSBS Valuation Tricks with Tom Bondi, CPA

It’s not what you make – it’s what you keep! Qualified small business stock (QSBS) regulations are designed to help investors save on taxes. Eric Sundheim, ASA of Mercovus Valuations sits down with Tom Bondi, CPA, considered by many to be THE expert on QSBS. Tom walks us through the basics and not-so-basics of QSBS. And, of course, we ask Tom about the roles valuation plays in taking the QSBS deduction. If you use Tom’s valuation tricks, you can dramatically lower your tax bill!

Eric: Hi everyone, I’m Eric Sundheim with Mercovus Valuations. I’m pleased to be joined today by Mr. Tom Bondi, CPA. He’s going to be talking with us about QSBS. Welcome Tom!


Tom: Thanks Eric – I’m pleased to be here.


Eric: Tom has shared a lot of information with me about taxes, and I thought this would be a great opportunity for him to share some of his wisdom with you. He’s known in the Bay Area as THE QSBS expert. So, Tom, what is QSBS?


Tom: QSBS is qualified small business stock. Do you want me to go into detail now?


Eric: Yeah – I’ve heard of 1202. Is that the same thing?


Tom: Section 1202 of the Internal Revenue Code – that’s exactly right. That’s the governing code section for determining whether someone has stock that may or may not qualify.


Eric: Okay – well why would I want QSBS?


Tom: Good question! So – here’s the thing. If you have shares of stock in a qualifying C Corporation (not an S Corporation), and you hold those shares for at least five years, and during substantially all that holding period, if the company continues to meet the qualifications of 1202, then you may be able to exclude the greater of $10 million or ten times your basis in the sale of that stock upon a liquidity event. That’s a big deal.


Eric: They tell us when we’re growing up to save your money and invest, but then you have to pay taxes. And you’re telling me, maybe I don’t have to pay taxes.


Tom: You may not. California stopped utilizing section 1202 back in 2013, but there are still some half the states that do allow 1202, and there are shareholders and investors all over the country, so you never know which state it will necessarily be taxed in. Because, you’ll recall, when you do leave to reside in another state, capital gain is taxed in the state where you reside.


Eric: At least for now…


Tom: At least for now. [laughs]


Eric: So, at least federally, people who are investing in QSBS, their capital gains rate is probably 15% or 20%, we’ve got the net investment income (NII) tax – which I find a lot of people still don’t know about – the Obama era tax of 3.8% on investment income. So we’re saving, at least federally, up to 23.8%.


Tom: That’s correct, yeah.


Eric: And if we buy the stock when we’re in California, but then we retire and move to Florida and sell the stock at that time, we’re avoiding the state tax as well?


Tom:  That’s correct – you potentially still avoid the state tax.


Eric: Fantastic. So, I’m interested. How do I get QSBS?


Tom: Yeah – good question. So, first off, the stock must be originally issued by a domestic C corporation. So, we’ll just keep this really simple because there’s lots of ways in which people really error in this. But if I buy my shares originally from a domestic C corporation, and at the time I buy my shares, the company had total gross assets, from a tax perspective, of less than $50 million, it’s possible my shares qualify. And the reason I say it’s possible is because there are other factors in section 1202 that require the company to meet certain qualifications. For example, it’s gotta be a qualified trade or business. It can’t be an accounting firm, a law firm, services firm, brokerage, bank: It’s not meant for services companies. Although, it does apply to many, many others. For example, people that own just a small store, or any kind of a product or potentially SaaS model company, pharmaceutical company, they may qualify. So, you gotta really look into if the trade or business meets the qualifications.


Eric: Okay – so there’s a couple criteria I heard you mention. One is that you and I are out of luck.


Tom: We’re out of luck! [laughs]


Eric: So no QSBS for us when we sell our businesses. Another criterion I heard is that it has to be an original issuance. So, if there’s another angel investor, and I get the stock from him, it’s not QSBS for me.


Tom: That’s right. That selling shareholder may be able to, but because I acquired my shares from that other shareholder, then my shares will never qualify.


Eric: Got it. And then we started talking about valuation criteria now which is near and dear to my heart. So, when you said $50 million, we're offering valuations for these companies frequently for a number of purposes. You know, many times these companies need 409A valuations. So, if I calculate within the 409A valuation that the company's equity value is worth less than $50 million, that's not what we're talking about.


Tom: That's not what we're talking about. We're talking about gross assets of the company from a tax perspective. And so that has really, other than some other exceptions, it has nothing to do with valuation. It has everything to do with the gross tax assets, and that may be very different than the financial statement gross assets. As a simple example, since 2022, R&D expenses of companies which used to be always expensed from an accounting perspective - and tax - are now required to be capitalized and amortized. So you may have, on the financial statements, nothing on the balance sheet because it was expensed in R&D; but from a tax perspective, it has to be capitalized. So you have got to be careful about looking at the companies and determining the gross assets. But generally you're going to be able to take a snapshot and see what the balance sheet looks like, and if it's anywhere close to 50, then you're going to be a suspect as to whether it qualifies or not.


Eric: Got it. And it's the assets after the investment. So, if the firm were to receive $60 million, then it's no longer QSBS eligible.


Tom: Not true. No. So, if I acquire my shares, and let's say the company had $20 million in total gross assets, and I acquire my shares. And then some months later, the company raises, let's say $40 million. And so - a couple of things there. Number one, what does the balance sheet look like when I acquire my shares? Because even though they had already raised money, we're saying that the assets on the balance sheet were already $20 million, right (in my example)? And so now I go raise $40 million so the total assets bump up by $40 million, right? So now, the companies at $60. So, when the company crosses the threshold of $50 million in total gross assets, then only the shareholders of record prior to that time have the possibility of obtaining 1202 benefits.


Eric: Got it. And you told me about a neat trick for one of your clients that they should have taken advantage of: If you know you're going to cross that threshold, you said they could stage their investment.


Tom: That's right. And there are many situations where, if a company is going to be raising some funds, if they sometimes just tranche the investments so that they come in over a period of time (months) - so that maybe it's series A1, series A2, or series B1, series B2 -they might be able to stay under that threshold for quite a long time. And I had one company, a venture group I worked with, they had put some 15 tranches of investments into a company through four funds; and had they just paid attention to one in one year, they probably could have picked up another 6-7 years of qualifying stock. So it's important for the companies to pay attention to this.  And they often don't understand the benefits to, not only the investors and founders, but to the new investors coming in.


Eric: Absolutely. And we see all the time that they think taxes are going to be a nice problem to have, but you're not in this game unless you're planning to pay taxes at some point.


Tom: Yeah, you're talking about the ROI you can get (return on investment). So it's a valuable thing for founders, CFO's, and general counsels to pay attention to, and unfortunately most people in the country, let alone Silicon Valley, don't understand this provision: And they make they make incorrect assumptions all the time as to whether it qualifies.


Eric: And one of the other criteria that I know we've done valuations for is that there's this 80% rule. Can you tell us about that?


Tom: Yeah, good question. The assets that are used in the trade business, it must be at least 80% of the total assets. So, like I said, there are a variety of qualifications in section 1202. One of them is that at least 80% of the assets need to be used in the trade or business. And also that you can't have more than 10% of assets that are held for investment. So, you have situations sometimes where a company raises a substantial amount of money. And then they maybe put it into investments, because they don't need it right away. So, there's a danger. You've got to be careful about how is that money being invested, so that you could still argue that 80% of the assets used in a trade or business. But if we went and bought a building, let's say. And let's say it was a five-story building and we used one floor for the business. And the other four floors we rented out. And that becomes significant because that's not used in the trade or business, those other four floors.


So that alone could disqualify the company. Now what's really important, is that because the company does not meet certain qualifications of 1202 for some period of time, that does not mean that your stock does not qualify. Right? Remember the definition is that “during substantially all one’s holding period, the company has to continue to meet the qualifications.” So, it's not just when you buy the stock, it's throughout your holding period, okay? And your holding period may be 6, 7, 8 years. It may not be just four or five years. But if the company did not meet certain qualifications - for example, maybe they had some investments that took it over 10% for some period of time - what period of time was that? And how material is that to all of the overall qualifications of 1202 to determine that the company did substantially or not substantially meet the qualifications?


Eric: So, there is some leeway.


Tom: There's a little bit of leeway and. And just remember this: The burden of whether the shares qualify is not on the company, it's on the shareholder themselves. The problem is the shareholder doesn't really know all the facts.


Eric: Where do they get their information from…?


Tom: They've got to be able to get information from the company, ideally, and the danger for the company is saying, “hey, your shares qualify,” when, in fact, they should not be giving that tax advice. All the company should be saying is, “the company did or did not meet these various qualifications of 1202 and it's up to you, shareholder, and your tax advisors to determine if you meet the qualifications - primarily because there's a lot of reasons shares may not qualify at the individual level, yet the company met all the qualifications.


Eric: Got it. So, you don't want to take on that liability as a company to state whether or not the shares are QSBS eligible.


Tom: That's right. It's a danger because, let's say that you call up the company. You say, “hey, do my shares qualify?” And they say “yes.” OK. Well, what if you acquired shares in four or five different transactions? The company may be thinking, “this one block of shares qualifies,” and you may be thinking, “all my shares qualify.”


Eric: That makes sense. So, the rule for the asset threshold exists because they don't want you investing in some holding company that then invests in the stock market or some non-eligible business. Then you’d get the QSBS benefits for something that's intended to promote investment in small businesses.


Tom: Well, yeah, in growing companies. It’s to incentivize putting investments into companies to keep the growth going, right?


Eric: But the assets could be - we mentioned tangible assets like a building or cash - but they could be intangible assets as well.


Tom: That's right. It could be intangible. It could be IP, other types of things that are actually used in the trader business, right?


Eric: So, let's say we've worked with you. We've dotted all our “i"s and crossed all our “t”s and we're QSBS eligible. How much can we exclude in our savings?


Tom: Well, this is an interesting thing about 1202. The definition is the greater of $10 million or ten times one’s basis. Basis in this situation may not be tax basis depending on how the ownership of shares came about. OK? But let's just assume, to keep it simple for the audience, let's assume that I buy the stock at $1,000 and now it's worth $15 million. So how much can I exclude? Well, the greater of ten times my basis, which is $10,000, or $10 million. Now it doesn't stop there, because we have other benefits that can come about which such as “stacking,” where I might be able to gift some of my qualifying shares to irrevocable trusts for my children. And each of those shareholders have the greater 10 times basis or $10 million. So that's called, “stacking.” That could be a real benefit if you are fortunate enough to have a good liquidity event.


Eric: That makes sense. So if you're investing cash, it's pretty clear what your basis is. But you made me aware of this LLC conversion strategy. Can you tell us a little bit about that?


Tom: Yes [smiles]. And this is something I work on regularly these days. This gets really complex, but let's just try to keep it simple. Let's assume that Eric and I have a partnership and we've been putting money into it, but we've been spending that money. So we have losses. So, from a tax perspective, our tax basis of the partnership is zero, because we took all these losses. OK? And now we're going to do what's called a “conversion.” Which is putting that into a corporate form. It's a transfer, and for those of you who like to write down things, this is section 351. So, we do a transfer in typical conversion into a C Corporation. And now we have to know what's the value that's going into that corporation.


Eric: And how do you know that? [smiles]


Tom: We contact Eric and say, “would you go do a valuation for us?” Because we need a value of the business - that's the assets that are being transferred in. OK. So let's assume in our example that the value of that business is $20 million. And we're going to go raise some money afterwards to get diluted. From section 1202 purposes, because it was via that transfer, then the term “basis” applies to the $20 million. So now, folks, the maximum gain is the greater of $10 million per shareholder or ten times one’s basis. Well, because our collective basis, under 1202, is $20 million, the potential gain exclusion now becomes $200 million.


Eric: Wow!

Tom: So, in a simple format, how does that work? Let's assume that that's all we have. And then, down the road, we hold these shares for more than five years and we sell that stock and let's just say it's sold for $300 million. And we cashed out totally - to keep it simple. So the first $20 million is gain associated with the value of the partnership that converted over. And you can't change that character. The next potentially $200 million might be 1202 gain that's excluded from federal taxation (and maybe some states). And then the gain above and beyond that would just be capital gain subject to capital gains tax and net investment income tax.


Eric: OK. And so that's where all your hours are spent.


Tom: That's where all the hours are being spent. There's a lot of activity in that area. But, let's get a little more complex, because some of you may have an S corporation. Now you've got kind of a problem there because, when the S corporation in the same scenario I just gave you where the value was $20 million - we're trying to get to a C Corp. OK, now couple of things there: If all we do is terminate the S election, those shares that we own will never qualify, because they were not originally issued by a C Corp. OK? So, now we want to get to a C Corp format. So how do we do that? Well, generally speaking, we would be transferring (just like in a partnership) we'd be transferring all those assets into a new C Corporation. We get a valuation (we already said it was $20 million). Now, we're not getting rid of the S Corp, and the reason we can't get rid of the S Corp is because, remember I said that our tax basis was zero. So now if we have a business where assets are being transferred to a C Corp, if we were to distribute those shares of stock out to the shareholders of the S Corp and get rid of the S Corp that's considered a distribution.


And now I've got a distribution of $20 million with no tax basis. I am going to pay tax on that $20 million because I got an asset worth $20 million distributed out. So in that situation what happens is the S Corp stays alive. And, basically it has on the books, investment in C Corp of maybe a dollar or whatever, $100, whatever the value, that's the tax basis will be on the financial statements. And so now the S Corp is holding shares of a C Corp, and once that C Corp stock is eventually sold (assuming it continues to qualify) then that gain from the sale of that stock will flow through the S Corp to the individual shareholders and they'll have 1202 gain flow through.


Eric: Well, my head is spinning. It sounds like this is a very complex area, Tom, but I think we got a good overview. If you have more questions about this, please reach out to Mr. Tom Bondi, and I appreciate your time.


Tom: Or contact Eric. He always knows. How to get a hold of me. [laughs]


Eric: Alright. Well, thanks so much, Tom! Appreciate it.


Tom: Alright – thanks for joining us!

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