The recent shutdown of Silicon Valley Bank ("SVB") introduces many issues for startups, their founders and venture capital investors. The current disruption has also triggered concerns of contagion in the startup banking space and the prospect of a funding crunch in the venture-backed startup ecosystem.

As founders and startups address their critical banking needs, they must also keep in mind that significant changes to how they manage business funds can have consequences for status as qualified small business stock ("QSBS") under Internal Revenue Code ("IRC") section 1202. Just as relatively routine corporate transactions—such as redemptions and recapitalizations—can have unintended tax and QSBS consequences, so too can seemingly benign investment decisions. In the present case, certain tests regarding cash, investments, and relative asset values are among the many requirements for a company to maintain QSBS status and provide exclusion benefits for eligible shareholders.

For example, compliance with the IRC section 1202(e)(B)(5) investment limitation is critical when moving funds to a new financial institution.  Capital held in accounts characterized as "mutual funds" or similar securities structures should generally be avoided in favor of short-term treasury notes and other highly-liquid investments. Otherwise, there is a risk the corporation may run afoul of the limitation on stock or securities in other corporations.

Fortunately, the QSBS rules are somewhat forgiving on this point. For "substantially all" of the stock's holding period, at least 80% of the company's assets by value must be used in the active conduct of qualified trades or businesses. A company fails this test in any period where more than 10 percent of the value of its assets consists of stock or securities in other corporations, other than its own subsidiaries. After the first two years of the company's formation, only half of "working capital" counts toward assets used in the active conduct of qualified trades or businesses. Cash and short-term investments over the threshold represent disqualifying assets later in the startup's growth cycle. Thus, if the startup inadvertently buys stock or securities, this violation of the investment limitation is not fatal for QSBS benefits. As long as the funds are transferred back to a traditional cash or working capital account in a relatively short period, the shareholder should still be able to meet the substantially all test for QSBS benefits.

These QSBS rules are intended to exclude any corporations that are passive investment vehicles but the taint can be triggered inadvertently without mindful planning. Furthermore, regular valuation data is critical to ensure the relative asset values meet the mechanical tests under IRC section 1202. Absent a recent term sheet or a capital raise, companies may consider third-party appraisals to establish total fair market value in the business on a periodic basis to confirm QSBS status throughout the relevant holding period.

Founders and VCs with questions about QSBS during this turbulent time can contact Christopher Karachale, Daren Shaver, Nancy Dollar, and the Hanson Bridgett Tax Group for assistance.