7 minute read | March.21.2023
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:
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.