Preferred Equity and QSBS

Preferred Equity QSBS

For any security to qualify under Section 1202 as Qualified Small Business Stock, the company must first be considered an eligible Qualified Small Business (QSB) meaning:

The securities themselves must also satisfy certain criteria including:

  • They were acquired at original issuance
  • They were acquired in exchange for money, other property (not including stock), or as compensation for services provided to such corporation
  • They were held for a minimum of five years

For each security type however, when the 5-year holding period begins is determined based on nuances particular to each security type. Depending on the security type the holding period might begin on the purchase date, the exercised date, vesting date, etc. 

What is Preferred Equity?

Preferred Equity is a type of capital structure that can be beneficial for private lenders and investors. The private lender is placed in a preferable position for repayment from any profit earned or cash flow. They are placed behind a senior lender, such as a first or second mortgage—in case there was a bankruptcy—but in front of other sponsors or investors who hold common stock/equity. This structure provides a reduced risk exposure for the preferred equity investor because their debt repayment is of greater importance than that of common shareholders or common equity investors.

Is Preferred Equity eligible for QSBS?

Qualified Small Business Stock, or QSBS, can be preferred stock, common stock, or convertible preferred stock and there are no limits with respect to voting rights. An unlimited number of rounds of QSBS can be issued by a corporation as long as they meet the requirements for a qualified small business at the time of issuance. Some things to consider:

  • A QSBS must be held for at least 5 years.
  • The corporation issuing the QSBS must be a qualified small business.
  • The corporation issuing the QSBS must meet the active business requirements.
  • A corporation will not qualify for QSBS if it holds too much investment assets, cash, or real estate.
  • A corporation will not qualify for QSBS if it redeems or reissues stock when it is close to the issuance of the QSBS.
  • Gains from the sale of a QSBS may potentially roll over (1045) if it has been held for at least 6 months and if the rollover happens within 60 days of the sale.

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.