Silicon Valley Bank Collapse Highlights QSBS Issues

In the wake of Silicon Valley Bank’s failure earlier this month, many technology companies are re-examining their treasury management programs and are considering moving cash into a variety of non-demand-deposit instruments, including money market funds, certificates of deposit, Treasury bills and Treasury funds, among other options. 

For companies that are domestic C corporations and to whom qualified small business stock (QSBS) status of their stock is relevant, any change should be implemented so as to not jeopardize their QSBS status. 

There are many requirements that must be satisfied for stock of a company to qualify for the U.S. federal tax benefits applicable to QSBS.  However, with respect to a company’s cash management activities, the rules that perhaps are most directly implicated are (i) the active business rule, (ii) the working capital rule, and (iii) the 10% limit on investments in portfolio stocks and securities. 

The Active Business Rule.  In order for any stock held by a taxpayer to be eligible for QSBS tax benefits, one of the requirements is that during substantially all of the taxpayer’s holding period for such stock, at least 80% (by value) of the assets of the corporation must be used in the active conduct of a qualified trade or business. 

For this purpose, cash, cash equivalents and other investment-type assets (e.g., deposits in checking, savings or money market accounts, certificates of deposit, marketable securities, Treasury bills and commercial papers) would generally not be treated as used in the active conduct of a qualified trade or business, unless they qualify under the working capital rule below.

The Working Capital Rule.  Any assets will be treated for this purpose as used in the active conduct of a trade or business (i.e., will count towards the 80%) if such assets (i) are held as part of the reasonably required working capital needs of a qualified trade or business of the corporation, or (ii) are held for investment and are reasonably expected to be used within two years to finance research and experimentation (R&E) in a qualified trade or business or increases in working capital needs of a qualified trade or business.  If the corporation has been in existence for at least two years, no more than 50% of the assets of the corporation can qualify as used in the active conduct of a qualified trade or business under the working capital rule.

The 10% Limitation on Portfolio Stock or Securities.  A corporation shall not be treated as meeting the active business requirement for any period during which more than 10% of the value of its assets (in excess of liabilities) consists of stock or securities in other corporations that are not subsidiaries (other than assets that qualify under the working capital rule described above).  For this purpose, a “subsidiary” means a corporation in which the parent owns more than 50% of the combined voting power or more than 50% in value of all outstanding stock.

Cash, deposits in checking or savings accounts, certificates of deposit, Treasury bills and other government bonds should not count towards this 10% limitation, nor should money market accounts so long as such accounts are deposits at banks or other financial institutions and are not used to invest in securities, money market funds or other funds.

Recommendations:  In adopting updated cash management policies, companies should keep QSBS requirements in mind. The ability of the company to qualify as much of its cash and cash reserves as is possible under the working capital rule described above will be important. To the extent any assets are not included as part of the working capital rule, care will be needed to ensure that such assets do not violate the 10% limit, nor otherwise cause less than 80% of the value of the company’s assets to be considered not used in a qualified trade or business. 

Along these lines, the following general recommendations (among others) would likely be appropriate in most cases:

• In conjunction with their adoption of cash management policies, companies should carefully examine the details surrounding their cash investments. Money market accounts, in particular, may have variations in terms across different financial institutions regarding how the funds will be invested (i.e., some may be invested in mutual funds or other corporate securities, in whole or in part), which can impact a company’s QSBS risk profile.
• As part of its cash management policies, companies should also carefully document their projected future uses of cash, and such projections should be analyzed to determine if they support treatment of amounts set aside to reserve for such uses as being held as part of the reasonably required working capital needs of a qualified trade or business, or as being reasonably expected to be used within two years to finance R&E or increases in such working capital needs.
• Such projections should then be periodically updated and supplemented, as appropriate.
• Cash should be invested and managed in a manner which is consistent with such projections. For example, short term cash needs should be supported by investments of cash in relatively liquid instruments.
• For companies that have been in existence for more than two years, attention should be paid to the requirement that no more than 50% of the assets of the company can be classified under the working capital rule.
• Given the 10% limitation on portfolio stock or securities (subject to the working capital rule), all else being equal, the company should exercise caution against placing cash in stock and securities of non-subsidiary corporations; with preference given instead to investments such as cash, deposits in checking or savings accounts, certificates of deposit, money market accounts (to the extent they are not used to invest in securities, money market funds or other funds), Treasury bills and other government securities.
• Investments in money market funds and other mutual funds would, technically speaking, likely be treated as “stock” in “corporations” for this purpose and count towards the 10% limit (unless satisfying the working capital rule).With respect to money market funds, though, given their cash equivalency, there may be good arguments that such holdings should be excluded from (and not count towards) the 10% limit. Nevertheless, because the working capital rule is not well defined, and because of the potential per se failure of the active business requirement that can arise upon violations of the 10% limit, caution should be exercised with respect to any placement of cash in money market funds or other mutual funds.
• For the 80% test for the active business requirement, the legislative history to the QSBS rules indicate that the company’s intangible assets should also be taken into account. For example, technology companies that are engaged in the active conduct of developing or producing software and are generating royalties therefrom should be able to count such software as an active asset based on its fair market value. Even for early-stage companies that are not generating any gross income, any assets used in start-up activities, such as investigating or creating an active trade or business or R&E, may be treated as used in the active conduct of a qualified trade or business. However, valuation of intangible assets is an inherently fact-intensive exercise and caution should be exercised in relying on such assets to satisfy the active business requirement.

Because the active business requirement needs to be satisfied during “substantially all” of a stockholder’s holding period of stock, the company’s management and use of its cash will need to be monitored carefully on an ongoing basis with these rules in mind.  Orrick’s tax team is highly experienced with these rules and can work with the company’s accountants, auditors, controllers or other similar professionals to ensure that the company’s actual uses of their cash comply with these rules, and that its corporate books and records appropriately reflect and support its intended tax positions.

To discuss any of these matters further, do not hesitate to contact any Orrick tax attorney.