Sweating the Small Stuff: How Private Equity Funds Can Pass the Benefits of Qualified Small Business Stock to Their US Taxable Investors

Overview and Requirements of the QSBS Exclusion The three main requirements for stock to qualify as QSBS are: (1) the taxpayer must purchase the QSBS at original issuance (the Original Issuance Requirement); (2) the issuer must be a qualified small business (QSB) on the issuance date meaning that its gross assets must be below a certain threshold (the Asset Test); and (3) the issuer must be a taxable "C" corporation3 that uses 80 percent of its assets, by value, in a qualifying active trade or business (the Active Business Test), and satisfies certain other requirements for substantially all of the taxpayer's holding period.4 Original Issuance Requirement QSBS must be acquired at its "original issue" by the taxpayer such that the taxpayer receives the stock directly from the corporation in exchange for money, other property (not including stock), or as compensation for services to the corporation.5 Stock that is secondarily purchased from a prior holder is ineligible for the QSBS Exclusion although the Original Issuance Requirement contains a limited exception for certain secondary transfers of stock such as a gift, a transfer resulting from the death of the transferor, or a distribution from a partnership to a partner.6 Although these exceptions to the Original Issuance Requirement are not the focus of this article, we note that they can be particularly useful for estate planning purposes. Because startup companies often have low basis in certain valuable assets (for example, goodwill), they may pass the Asset Test where the gross fair market value of their assets exceeds US$50 million. Active Business Test During substantially all15 of the investor's holding period in the QSBS, the issuer must use at least 80 percent of its assets (measured by value) in the active conduct of one or more eligible business activities.16 An eligible business activity generally is any business activity other than certain enumerated service activities.17 The Active Business Test also requires that no more than 10 percent of the corporation's net assets may consist of either the stock or securities of another corporation (other than majority-owned subsidiaries as described below) or real property that is not used in active conduct of a qualified trade or business.18 For purposes of the Active Business Test, the stock of a 50 percent-or-greater subsidiary corporation is disregarded, and a corporation will be treated as owning the assets and conducting business of subsidiary cor