#215 VC Fund Taxes Simplified & QSBS

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VC Fund Taxes Simplified, QSBS, & Why It Matters

For VC GPs, CFOs & Finance Pros, fund taxes & QSBS matter! Doing it right can save millions of dollars! Doing it wrong can cost you your job. Below, we break down key concepts, insights, and pitfalls on VC Tax & QSBS. Enjoy!

VC TAX 101

We recently dove deep into “A Guide to Fund Taxation” by Sydecar. The majority of VC investment vehicles (i.e. venture funds and SPVs) are pass-through vehicles, meaning that the responsibility to report gains/losses for tax purposes is passed through to the underlying investors.

This setup avoids the double taxation typically seen in corporations, where income is taxed at both the corporate and the shareholder levels. The most common forms of pass-through entities used in venture capital include Limited Partnerships (LPs) and Limited Liability Companies (LLCs).

Key Tax Components for Venture Funds

1. Carried interest: taxed as a capital gain. A fund’s governing agreement (LPA) outlines how carried interest is allocated to GPs and other investment team members, who are then liable for taxes on this income.

2. Management Fees & MgmtCo Income: mgmt fee revenue - operational expenses = taxable income. This is subject to ordinary income tax rates.

3. Realized Gains (Carta): GPs and LPs both must pay taxes on their share of a fund’s taxable income. Most funds can ignore this until they get into DPI.

In Carta’s report, they note that the tax rate each partner owes on the capital gains (K-1) depends on how long the fund has held the underlying investments. Each financial situation is different so consult your tax advisor! Carta shares the following guidelines:

• If the fund holds an asset for less than three years, the associated gains will be treated as short-term capital gains, which tops out at 37%. The exact rate you pay in capital gains taxes depends on your adjusted gross income.

• If the fund holds an asset for three or more years, the associated gains will be treated as long-term capital gains, which tops out at 20%. As with short-term capital gains, the rate you pay depends on your adjusted gross income.

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QSBS: Qualified Small Business Stock, Simplified

What is QSBS?

QSBS is a tax incentive designed to encourage investment in small businesses. To qualify for QSBS benefits, certain criteria must be met:

1. Qualified Small Business: The company must be a domestic C corporation with gross assets under $50 million at the time of stock issuance.

2. Active Business Requirement: At least 80% of the corporation’s assets must be used in active business operations.

3. Holding Period: Investors must hold the stock for at least five years to qualify for the exclusion.

Theoretical Impact of QSBS

To understand QSBS better, our friends at Sapphire showed a theoretical example: Consider Taylor, a founder who develops innovative AI technology for applying long-lasting lipstick. After initially funding her company at a negligible cost basis, she raises $5 million at a $20 million valuation. An angel investor, Travis, invests $1 million, while venture firm KC Capital contributes $4 million.

Four years and ten months later, Taylor receives a $100 million acquisition offer. After negotiating to close the deal post five-year mark, all investors leverage QSBS status, significantly reducing their federal capital gains tax burden.

Impact Breakdown:

• Taylor: With an almost zero cost basis, she benefits from an additional $2 million in after-tax proceeds.

• Travis: Gains an additional $800K in after-tax profits.

• KC Capital: While not taxed at an individual level, GPs and LPs could collectively see an increase of $3.2 million in after-tax proceeds.

Although Taylor's percentage increase seems modest at 4%, her low cost basis results in substantial total savings. However, residents in high-tax states like California face limitations since they do not benefit from state-level QSBS exclusions.

Common QSBS Pitfalls

• Inadvertent Disqualification: Structural changes, like converting from a C corporation to an LLC, can disqualify QSBS eligibility.

• Insufficient Documentation: Failing to track and document QSBS eligibility from the start can complicate tax filings.

Considerations for Founders and Investors

It's crucial to document and track QSBS status accurately. While tax savings can be meaningful, decisions should prioritize what's best for the company. If an attractive offer arises before reaching the five-year mark, accepting it might be more beneficial than holding out for QSBS reasons. As noted by Sapphire Ventures, "the priority should always be what’s best for the company"

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Want To Dive Deeper?

Accurate fund and budget models can provide the insights needed to navigate these complexities. Below we’ve compiled some of our top premium templates designed specifically for VC firms. Enjoy!