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.)