The QSBS Chicken and Egg Dilemma

Question:

I’m a startup founder raising a pre-seed round of about $1 Million from angel investors. A few of the angels are asking for assurances that their investment qualifies for Qualified Small Business Stock (QSBS) treatment. Can you craft an attestation letter so I can give these angels to confirm the QSBS exemption?

Answer:

This is always a tough request from potential investors. I understand it, because QSBS has such huge potential tax savings, but it is a little bit of a chicken and egg situation. The test for QSBS eligibility is measured in the future, even though investors are asking the company to represent something today.

If I were in this situation, and to avoid engaging a legal or tax firm to write a letter, I might share a QSBS checklist that details the IRS Section 1202 requirements and highlight how you can “check the box” on those requirements, as of today anyway. I might also add my own explanation, such as:

Dear Investors,

Thank you for your interest in investing in our startup. I understand some of you have asked about Qualified Small Business Stock (QSBS) treatment for your investment.

While I am optimistic that the company will meet the QSBS requirements in the future, QSBS eligibility is based on certain ongoing tests that cannot be fully determined today.

Based on my analysis of the requirements (e.g. less than $50 million in assets, having a business model that the IRS considers “qualified” for QSBS treatment), it is my understanding that the company’s stock currently meets the QSBS exemption. However, since QSBS treatment depends on meeting certain ongoing criteria over time, I cannot provide definitive assurance of future QSBS eligibility.

I recommend we revisit the QSBS analysis once the company’s operations and financial position become more established. At that time, we can engage a firm to conduct a more thorough QSBS analysis.

In the meantime, please let me know if you have any other questions! I look forward to partnering with you as an investor in our exciting startup.

Sincerely,

[Your Name]

[Startup Name] CEO

Hopefully this meets the needs of your potential investors. If not, and you still require a third-party QSBS assessment and attestation letter, you might chat with your legal or tax team to see what they will charge (and if they are willing to do it). You can also check out Carta. According to their website, Carta’s Tax Advisory team can provide QSBS attestation letters. Source: https://carta.com/blog/qsbs/

The main takeaway:

  • QSBS offers big potential tax savings for investors, but eligibility depends on ongoing tests.
  • Startups can’t guarantee QSBS status upfront, but can share expectations.
  • Providing a QSBS checklist and explanation letter is a good interim step.
  • If investors still want third-party assurance, services like Carta can provide QSBS attestation letters.