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Matter of Nag and Rudd – Deal Considerations for Founders with QSBS

Matter of Nag and Rudd – Deal Considerations for Founders with QSBS

Not-So-Special Dividends: Preserving Basis for QSBS Tax Benefits

The California Office of Tax Appeals ("OTA") recently issued an opinion in Matter of Nag and Rudd, OTA Case No. 18073501, which, despite dealing with a since-repealed qualified small business stock ("QSBS") California statute, provides a cautionary lesson for founders looking to maximize their QSBS exclusion opportunities. While special dividends can be a welcome sight for shareholders, Nag shows that such payments can limit founders' ability to obtain QSBS benefits.

As many in the start-up world are aware, Internal Revenue Code ("IRC") section 1202 allows certain founders, early employees, and venture capitalists to exclude $10 million of gain from the sale of their QSBS. However, the statute also provides a much more powerful exclusion benefit for shareholders with high bases in their stock. IRC section 1202(b)(1)(B) allows shareholders to exclude ten times their bases in their QSBS. For a founder with high basis in her stock, the potential QSBS exclusion can be hundreds of millions of dollars.1 Nag teaches what can go wrong when a founder hopes to use the 10x basis benefit, but improperly plans for the ultimate sale of her business.

Nagging Facts

In Nag, the OTA determined that Cellmania co-founder Ronjon Nag mischaracterized special dividends as merger consideration. A buyer offered to acquire Cellmania on a cash-free and debt-free basis. To reduce its cash and facilitate the merger, Cellmania issued special dividends to its shareholders, including over $5 million in dividends to Nag. Cellmania issued two such dividends, with the second dividend occurring the same day the merger was finalized.

When a corporation issues a special dividend, the shareholder must decrease her adjusted basis in her shares by an amount equal to that dividend, provided the company has no earnings and profits.2 If a corporation pays a dividend in excess of the taxpayer's basis, the taxpayer must pay capital gains tax on the difference (her basis already reduced to zero).3 Nag claimed his basis in Cellmania was about $1.6 million prior to the merger and special dividend. Therefore, if the $5 million Nag received was a special dividend, he would have to pay capital gains tax on a gain of roughly $3.5 million, and his adjusted basis would be reduced to zero.

However, Nag argued that Cellmania only issued special dividends as part of a multi-step merger transaction, and that the dividends were, in fact, part of the consideration he received for his Cellmania shares. Nag pointed out that by "linking together all interdependent steps with legal or business significance, rather than taking them in isolation, the tax liability may be based on a realistic view of the entire transaction."4 In this way, the substance of the transaction (i.e. multiple components of merger consideration) should be respected over its form (i.e. special dividend paid at roughly the same time as the merger). Thus, Nag argued that because no special dividend occurred in substance, his basis should remain unchanged and he should be entitled to exclude 10 times his basis in the shares or $16 million of QSBS gain.5

The OTA rejected Nag's argument, finding that Cellmania entered into a separate, legally significant transaction by issuing the special dividends. The OTA ruled that the special dividends were neither intended nor negotiated to be part of the purchase price, so even if they were issued in preparation for the sale, they were not consideration for the sale. The OTA affirmed that Nag's basis in Cellmania was properly reduced to zero.

How does Nag affect Founders and their QSBS

Although the Nag holding is based on the now repealed QSBS exclusion for California, the case illustrates the care and potential foot faults that founders can encounter when hoping to obtain federal QSBS benefits, especially when planning for the 10x basis argument. There are precious few judicial opinions at any level discussing the special dividend vs. merger consideration overlap.6

Nag is significant because the OTA upheld an aggressive position on what constitutes consideration (eligible for QSBS benefits) in the context of a merger. Consideration, i.e. bargained-for exchange, is the conceptual foundation of contract law.7 In the context of merger transactions, this can be a simple exchange: you pay me, I give you my company. However, the root exchange in Nag was slightly different: you pay me, I give you my company on a cash-free basis. If I have to dispose of my assets in order to complete this exchange, is that part of our bargain? The answer depends, but in Nag, the OTA said it was not.

The OTA found that Nag's pre-merger payouts from Cellmania were not merger consideration because, although the buyer sought to acquire Cellmania on a cash-free basis, the buyer had no interest in how Cellmania shed its excess cash. Furthermore, the excess cash did not factor into the acquiring company's offer price.

Notably, Cellmania issued the second special dividend the same day of the merger, with the obvious goal of disposing of its cash and facilitating the merger's completion. This was still not enough for the OTA to find that the dividend payments out of the company to Nag were merger consideration based on a substance over form argument. Wrongly decided or no, founders should remember that consideration for shares in merger transactions may require the terms of the deal to be explicitly defined.

So what's the Solution to the Basis Problem?

It's not all doom and gloom, thankfully: methodical founders can still sell their startups using the 10x basis argument without creating special dividend issues. Before we get into these workarounds, if you can avoid selling your business on a cash-free and debt-free basis, do so! The fewer transactions required, the better for QSBS planning purposes.

However, suppose that you are a founder in a position similar to that of Ronjon Nag, and you must dispose of your cash in order to facilitate a deal. Nag teaches that any disposition of cash should be negotiated into the merger agreement to be part of the overall consideration paid. Such documentation may help avoid characterization the payment as a special dividend and a reduction in basis. This way, the buyer obtains the target with an exchange of cash for cash, but the founders can retain their bases and the potential larger amount of gain subject to QSBS exclusion.

Failing the above, Nag implies that a court (and potentially the IRS) would apply substance over form arguments in certain situations. Thus, a special dividend might not have independent economic significance if paid only upon the merger's finalization, and a taxpayer could collapse the dividend into merger consideration. It is essential to note that the inverse of this strategy – agreeing to a merger conditional on the issuance of a special dividend – will not collapse the dividend into the sale and create QSBS opportunities for additional gain. The OTA stated in Nag: "had there been a change in circumstances causing the merger to fall through, Cellmania's shareholders would have been entitled to retain both their stock and the Special Dividends. Therefore, the Special Dividends were legally binding irrespective of the outcome of the sale."


While the California QSBS exclusion at the heart of Nag no longer exists, its reasoning remains relevant to federal QSBS rules under IRC section 1202. Founders who are looking to sell their companies and benefit from high bases in their shares – but who also have excess cash on hand in their startups prior to the merger – should pay close attention to the guidance in the case.

Please contact Trent Tanzi, Christopher Karachale, or the Hanson Bridgett Tax Group with any questions regarding Nag or QSBS more generally.



1    IRC section 1202(b)(1)(B) only provides meaningful benefits for shareholders who have a basis of $1,000,000 or greater in their shares. Otherwise, the $10,000,000 of exclusion under IRC section 120(b)(1)(A) is generally superior. But the IRC section 1202(b)(1)(B) exclusion can provide significant exclusion opportunities without recourse to trust stacking or related planning techniques.

2    IRC section 301(c)(2).

3    Id; see also IRC section 301(c)(3)(A).

4    Commissioner v. Clark, 489 U.S. 726, 738 (1989).

5    Again, we caution that Nag does not deal with the federal QSBS rules but the now repealed California QSBS benefits under Revenue and Taxation Code section 18152.5.

6    In making its decision, the OTA relies heavily on three cases which discussed whether pre-sale distribution of an unwanted asset was considered part of a sale: TSN Liquidating Corporation, Inc. v. U.S. (5th Cir. 1980), Waterman Steamship Corporation v. Commissioner (5th Cir. 1970), and Coffey v. Commissioner (1950) 14 T.C. 1410. The limited case law is apparent given that the OTA did not cite to any cases with direct precedential authority, nor any opinions issued within the last forty years.

7    Restatement (Second) of Contracts, section 17 ("The formation of a contract requires a bargain in which there is a manifestation of mutual assent to the exchange and consideration.")

For More Information, Please Contact:

Christopher Karachale
Christopher Karachale
San Francisco, CA
Trent Tanzi
Trent Tanzi
Los Angeles, CA