Generally, when talking about qualified small business stock (QSBS) someone is referring to the direct investment they made in a small business, stock options, or the founding of a business, but limited partners (LP) in a partnership also qualify. When an LP invests in an investment vehicle (e.g. traditional private equity or venture capital (VC) fund) their equity interest may qualify for QSBS. Although the LP is not directly purchasing QSBS their investment through the fund that is structured as a partnership is. One investment in a fund can unlock multiple QSBS tax exclusions; therefore, it is imperative for LPs and Managing Partners to be aware of the tax implications of QSBS before making investments. Below are popular Q&As over the topic:
Does the sale of my equity interest qualify for QSBS?
Selling an equity interest in a fund is not the sale of QSBS. The fund would first need to sell the QSBS and distribute the funds to the LP or the fund would need to distribute the QSBS to the LP to allow the LP to sell his/her QSBS. Selling an equity interest in a fund does not allocate value to each individual investment. The gain realized would be on the equity interest and not the individual stocks. The only exception would be a solely owned disregarded LLC, which is not treated as a pass-through or taxable entity for tax purposes.
Can I still claim QSBS if I purchased the PE fund’s equity interest after investments were made?
The current owned investments by the fund that qualify for QSBS would not qualify for QSBS for the new LP. Section 1202(g) states that any equity interest not owned on the date the QSBS was acquired will not qualify for Section 1202. For example if an investor purchased a 5% equity interest in a VC fund for an existing LP any gain allocation for existing stock owned by the fund would not qualify for QSBS, but future investments made by the fund would qualify. The future investments would qualify because the equity interest would have been owned on the date the QSBS was acquired..
I increased my equity interest in the fund does that affect my QSBS status?
The equity interest owned on the date the fund acquired QSBS equals the pro rata gain allocation available for Section 1202. Section 1202(g) states that any equity interest not owned on the date the QSBS was acquired will not qualify for Section 1202. For example if an LP owned a 5% equity interest in a VC fund and the fund purchased 100 shares of QSBS in ABC, Inc. the LP would have 5 shares of QSBS. If the LP later increased his/her investment to 10% in the fund for an allocation of 10 shares in ABC, Inc. the increased allocation of ABC, Inc.’s stock would not qualify for QSBS. The only stock that would qualify would be future investments after the equity interest was increased.
What if the fund I’m invested in acquires the assets of a company or has multiple controlling interest rollups? Due to the traditional Private Equity Group (PEG) business model of acquiring the entire existing equity pool or assets of a company it is tricky to structure the transaction to qualify for QSBS. We address QSBS transaction planning strategies for PEGs here.
This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.