Editor's Note: This article is part of the Financial Advisor series "How I Solved It." Advisors describe a client with a problem and what they did to help.

Shane Mason’s firm Brooklyn FI launched in 2018 to cater to creatives and young tech industry executives. From the beginning, the firm has benefited from co-founder Mason’s background at a Big 4 accounting firm, especially when it comes to the tech space and its thorny tax issues related to employee stock compensation.

“We’re still coming across things we haven’t learned before, which scares the shit out of me because I know that other people are working with advisors who have no idea how to deal with equity compensation and are ... frankly goofing it up all the time,” Mason said.

This year, the firm came across a problem with its clients at an e-commerce company that had issued qualified small business stock. The company was going public, and the first line of accountants missed the possible tax savings. In the end, he claims his firm ended up saving some of the employees at this company hundreds of thousands of dollars after it went public through a special purpose acquisition company, or SPAC, in 2021. About 15 or so Brooklyn FI clients are past and present employees of this consumer products company, and they include both executives and rank and file engineers. Further exclusions could end up saving these clients millions, said Mason and his director of financial planning.

After one review, Mason said it became apparent that a client's $500,000 gain actually qualified for a 100% exclusion from taxation. "So it saved them $175,000 in taxes,” he said.

The trick with SPACs, they learned, was figuring out what was and what wasn’t qualified small business stock, which grants holders huge tax exclusions up to a certain amount if they belong to the right type of company focused on the right type of business—a C corporation that’s not burdened by excessive outside business lines or property holdings (such as real estate).

In a regular IPO, a company’s shares are issued directly to the public. Not so in a SPAC, a publicly listed shell corporation that’s formed so it can eventually purchase a private company’s shares. When a SPAC takes a private company public, one of the ways it does so is by swapping or absorbing the private company’s shares in exchange for shares in the new entity (usually with an attendant stock split) and then—boom!—the once-private company is public. 

It's a complicated deal, and it gets worse when planners and accountants don’t understand the structure.

“The tax forms that come with equity compensation, oftentimes they are flat out wrong,” Mason said. “These forms go to the government incorrectly, including W-2s and 1099s. And there have to be manual overrides to them to accurately report what actually happened. Oftentimes that all costs clients hundreds of thousands of dollars if they have high enough income.”

After the shares go through the SPAC, they play a strange game of limbo. SPACs list at $10 a share. Up to that price, the original qualified small business stock is still eligible for tax exclusions, even after they have been converted into the new entity’s stock in a public offering.

A key thing to remember is that the new shares issued by the SPAC company do not themselves qualify as qualified small business stock. What continues to qualify is the pre-merger QSBS shares that are “frozen” at $10 during the deal. That means if you took hold of a private company share at $1 in 2015, you can save on the additional $9 per share appreciation when it comes time to pay taxes five years later after the company has gone public. That’s huge potential savings.

In a regular situation, when SPACs are not involved, the section 1202 exclusion for qualified small business stock is normally limited to $10 million per shareholder or 10 times the shareholder’s adjusted tax basis in the sold qualified small business stock, whichever is greater. Above that, the stock no longer qualifies for a tax exclusion under Section 1202 of the Internal Revenue Code. 

John Owens, the director of financial planning at Brooklyn FI, said clients have to hold on to their qualified shares for five years after the shares are exercised to be eligible for the exclusion. For his clients at the e-commerce company, “The main people that were impacted by this have been Brooklyn FI clients for several years now [who] exercised their shares when this company was in its infancy and long before any dreams of an IPO.”

“As time went on,” Owens said, “we got an influx of new clients from this company in early 2021 in the six months leading up to the SPAC.”

Since SPACs are all priced at $10 a share, the deals require stock splits or reverse splits depending on how much the private company shares are worth (the original $79 share in your private company, for example, would turn into 7.9 shares worth $10.00).

After the SPAC listing, if the company share price goes to $12 a share, the extra $2 the investor made over their qualified small business stock price is taxed as capital gains. Again, everything up to $10 is tax free. Many clients who were early shareholders in the e-commerce company and had exercised more than five years ago might be able to eventually exclude hundreds of thousands or even millions of dollars from their income in the next year or so, Owens says.

One of Mason’s new clients acquired stock in 2014 and had $1.3 million in proceeds. “So that’s $285,000 in taxes, and he didn’t even know about QSBS,” Mason said.

Another client who acquired shares in 2016 was able to exclude $646,000 in gains. “So that would be $220,000 in taxes [saved],” Owens said.

It’s likely other tax managers are missing this—Mason said one of his tax managers did too at first, but the clients got a top-level review from the firm. “There’s four levels of review for all our tax returns: preparer, reviewer, me and the financial planner, because it’s so easy to miss these things,” he said.

The terms of QSBS have been more favorable since the financial crisis. According to the Columbia Law Review, a 100% exclusion was first pushed in 2010 and became permanent in 2015. (Mason and Owens cautioned that California is more hostile to these exclusions in its state tax.)

Part of the reason for the confusion about these shares is that there are few court cases in the QSBS space, Mason said. “So all financial advisors have to rely on really soft evidence of what the intentions [are] within the [Internal Revenue] Code,” he said. Tech businesses qualify for QSBS, but healthcare, real estate and financial services companies don’t. Companies on the borderline—fintech or health tech for instance—usually get private letter rulings from the IRS, he said.

The e-commerce company clients Brooklyn FI worked with had a guidance letter from a Big 4 accounting firm, said Mason and Owens. Its employees had multiple exercise dates at 2015, 2016, 2017, etc., that made the process of finding qualified exclusions more challenging for Mason’s firm. (QSBS shares have to be directly issued by a company and can’t be bought through secondary channels.)

SPACs Stinking, Taxes Sinking
As Owens put it in blunt terms, many SPACs have performed “shittily.”

Or, as The Wall Street Journal put it in January, “Shares of half of the companies that finished SPAC deals in the last two years are down 40% or more from the $10 price where SPACs typically begin trading, erasing tens of billions of dollars in startup market value.”

But there’s a silver lining for those who held qualified small business stock beforehand. The shares might have started at $10 after the SPAC deals, but if they went back down, as many SPAC shares have, they still fell under the threshold for qualified small business stock treatment. So if a stock went up after a SPAC deal and then tanked afterward, there was still a tax benefit.

“For clients who sold it at $9 a share, they didn’t pay any tax on the gain because they sold it for less than $10 a share,” Owens said. And this particular e-commerce stock got hit hard. After an initial bounce, it has fallen to under $2 a share.

There are a few other stipulations worth noting for qualified small business stock. The company can’t have gross assets of more than $50 million at the time of share issuance (the e-commerce company in question eventually did reach that threshold sometime in 2019 or early 2020). Section 1202 explicitly leaves out “any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees.”

The problems with the tax filings aren’t just with the clients or their companies. Mason and Owens said that even the brokerage companies handling the shares mess up the filings.

“This is just one piece of the puzzle for what we did with this company,” said Owens. “We identified errors with W-2s and misreported cost basis to help our clients make sure that their stock plan transactions were reported accurately on their tax return ... where there was non-accurate reporting of their cost basis for sales that occurred because of the split. Even for folks that didn’t have QSBS, we were able to save a ton of money because of these sorts of issues.

“Basis for stock plan stuff is a mess across the board.”

Mason added that one of his clients had a 1099 showing a $700,000 loss on the sale of his stock in the e-commerce company. “Which is the exact opposite. He paid peanuts for them, probably $25,000, and the proceeds were $1.2 million, but because the brokerage didn’t know the actual basis, they just took the basis from the old brokerage when it was transferred over. ... So just put in the fair market value on the date of the transfer. And since the stock went down, the IRS thinks he has a $700,000 loss. We had to override that on the tax return and say, ‘Actually, no, he has a $1.2 million gain and it’s all qualified QSBS.’

“So it’s playing with fire with all this stuff. ... It’s just a landmine for advisors.”