March 2022 Q&A

March 2022 Q&A

QSBS Expert Q&A: Stock Redemptions and QSBS Regulations

The startup ecosystem and investment landscape are ever-evolving. As new questions develop, the answers and solutions are not far behind. In our monthly series, the QSBS Expert team provides insights into these pressing questions in the highly nuanced realm of QSBS.

Section 1202 (QSBS) is a highly nuanced portion of the tax code. Many of the questions that we receive deal with the expansion and delineation of these tax code details. Part of the conditions found within Section 1202 includes specific regulations surrounding disqualifying stock redemptions.

Recently, our team received a question that, when answered, will give a fuller insight into the detail of disqualifying stock redemptions. Our reader explained that their company was planning to undertake a redemption of outstanding convertible notes, and reached out to our team of QSBS experts.

Q: “Can the redemption of outstanding convertible notes be considered a disqualifying stock redemption from a Section 1202 / QSBS perspective?”  

To better answer this question, we will need to lay some groundwork about the background of this particular regulation found in the Section 1202 provision. 

The QSBS regulations include a prohibition against “significant (stock) redemptions” in IRC 1202(c)(3), where it states:

“Stock issued by a corporation shall not be treated as qualified business stock if, during the 2-year period beginning on the date 1 year before the issuance of such stock, such corporation made 1 or more purchases of its stock with an aggregate value (as of the time of the respective purchases) exceeding 5 percent of the aggregate value of all of its stock as of the beginning of such 2-year period.”

Based on this specific regulation, we also need to define what “stock” is from a QSBS perspective: 

“[T]he term “stock” for federal tax purposes is not restricted to cases where formal stock certificates have been issued. Rather, as noted in I.R.S. Priv. Ltr. Rul. 201636003 (June 01, 2016), “it has been consistent Service position that for federal tax purposes stock ownership is a matter of economic substance, i.e., the right to which the owner has in management, profits, and ultimate assets of a corporation” 

As per 26 U.S.C.A. § 1275(a)(1)(A), the “term ‘debt instrument’ means a bond, debenture, note, or certificate or other evidence of indebtedness.”

Convertible notes also have attributes of both debt and equity instruments, as the securities convert to equity if certain conditions are met, such as a subsequent equity financing round. Such securities have a debt component (i.e. face value plus interest) and an equity component (i.e. the “upside” to be realized if/when the security converts to equity).

Now that we’ve defined some key terms and pinpointed specific conditions within Section 1202, we can return to answer the question at hand.

A: In this situation, the company is redeeming convertible notes at a premium to the face value of the convertible notes, which represents the equity upside of those notes.  

To be conservative regarding the potential QSBS implications of the redemption, it may be best to evaluate the portion of the redemption tied to the equity upside of the note under the Section 1202 redemption guidance and see if it would meet the threshold of being a significant redemption.  

To provide a concrete example surrounding this explanation, suppose:

Face Value of Notes = $1,000

Notes are redeemed for $1,500

Equity portion = the $500 premium paid for the notes (assuming zero interest on the notes)

Equity value of Company one-year before the redemption = $20,000

To determine if redemption is “significant” for QSBS purposes, divide the $500 redemption amount by $20,000 total equity value = 2.5%  

Since the redeemed amount is less than 5% of the aggregate value of the equity, the redemption is not considered “significant.”

Our team is here to answer your specific QSBS investment questions. Here at CapGains, we help answer queries surrounding the highly nuanced nature of the QSBS tax code and how it may affect businesses and investments. 

Reach out and let us know what questions we can answer for you in our next monthly edition of QSBS Expert Q&A. 

In case you missed last month’s QSBS Expert Q&A, check it out here.

Capgains specializes in aiding investors and corporations as they navigate QSBS tax exemption qualifications. We are ready to provide guidance and support throughout the entire lifetime of your eligible stock.

Want to discover more about QSBS? Subscribe to get expert answers and insights sent right to your inbox, and never miss a monthly update. You’ll also get our “Quick Guide to Understanding QSBS Tax Exemption” for free.    

This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.

About QSBS Expert

QSBS Expert was founded by a group of entrepreneurs, investors, accountants and lawyers who came together when trying to navigate a QSBS situation of their own. We quickly realized that the regulations left a lot of open questions and the publicly available information was confusing to sift through…so we thought that others may also benefit from having a “go to” resource for all things QSBS.