Is a SAFE Safe for QSBS and 1045?
By Sarnaa Archie
A SAFE (Simple Agreement for Future Equity) is pitched as a simpler, more founder-friendly alternative to traditional equity. (I agree for reasons I won’t get into in this article.) But is a SAFE safe for Qualified Small Business Stock (QSBS) under Section 1202 and rollovers under Section 1045? Does it qualify as stock for QSBS and 1045?
Let’s dissect this.
First, what is a SAFE?
A SAFE is an investment contract between an investor in an early-stage company when it’s too early to come up with a justifiable price for the company’s stock and, therefore, difficult for the company to figure out how much of that stock to sell to the investor. The SAFE promises to the investor that once certain conditions are met (like a future funding round, a sale, a liquidation, or a dividend), the SAFE owner will in some way participate or have the SAFE convert into another investment form (common stock, preferred stock, etc.).
This conversion feature of the SAFE puts a wrench in the machine when thinking about it for QSBS.
The QSBS Conundrum
QSBS offers a tempting tax break for investors and founders. If you hold onto your shares for at least five years, you can potentially exclude up to 100% of your gains from federal income tax when you sell your shares. The catch? The stock must be "stock" in the strictest sense—issued by a domestic C corporation, among other requirements. The written law is explicit; the courts have been explicit, and this is not in question.
But what is sometimes a question is, “What constitutes stock?” No one has a clear, definitive answer. The tax authorities and the courts typically subject the instrument or contract to a “duck test.” (Looks like, walks like, quacks like.)
So, depending on who you ask if a SAFE is a stock—your friend, lawyer, accountant, or tax advisor—you’ll get a grocery basket of different answers based on various analyses. But the most common answer is “No.”
Rolling Over with Section 1045
If you’ve sold QSBS anytime short of the five-year holding requirement, your options are to pay capital gains taxes on the sale or roll over the proceeds into another QSBS under the rules of Section 1045 of the Internal Revenue Code.
Section 1045 allows investors to roll over the gains from one QSBS to another, essentially buying more time and potentially compounding their returns, as long as the rollover happens within 60 days of the sale.
How to do that can come in a variety of forms:
1) Start a New Venture. You can start a new company with the proceeds. But this only works if the business has a justifiable and demonstrated need for all the cash you inject into it. Otherwise, the tax authorities won’t buy it. You can do this, but not as a strategy to buy your QSBS some more time; your transaction will likely be unwound—and you’ll owe capital gains taxes, interest on the amount you owe, and potential penalties.
2) Invest In A Startup. You can invest in another startup that qualifies to have its stock treated as QSBS. In recent times, this has typically meant using convertible debt (which won’t count for QSBS and 1045 rollover purposes). You can also outright buy preferred or common stock in the company, or, as is more often the case now, for the reasons stated earlier, you’ll have to purchase a SAFE.
So, if this is your route, is a SAFE safe for QSBS and 1045?
Why I Think A SAFE is Safe for QSBS and 1045
Some say a SAFE doesn’t start its life as stock because of its name, and one of its features is that it promises “Future Equity.” But sometimes, so does preferred stock—and no one doubts that preferred stock with these features is equity. Some analyses start and stop with the title or overemphasize the future promise part and ignore all of the other features of the SAFE. Many of these analyses judge the book by its cover and ignore entirely or in part its substance.
In the tax world, legal jargon aside, there is something called the “substance over form” doctrine. This could be the key. This principle suggests that the tax implications of any transaction should reflect its substance rather than its form. Since a SAFE fundamentally acts like stock (providing permanent capital to the company, participating in dividends and liquidations like stock), it might argue its way into being treated as such for tax purposes right from the start. The SAFE agreement says so in the contract text.
But, and it’s a big but, some feel SAFEs are still a gray area. The IRS hasn’t laid concrete guidelines on how SAFEs mesh with QSBS or Section 1045.
Reinvesting early QSBS proceeds via a SAFE might be strolling through a regulatory fog. If your primary allure to investing in startups is the QSBS tax benefit, a SAFE might not be your best bet. Until we see definitive guidance from the IRS, or until SAFEs are universally recognized as stock from the get-go, the safe path is to tread carefully or consider more traditional forms of equity if it’s the tax benefits you want more than the potential for significant return on your next venture investment.
Bottom Line
We're in a vibrant era of innovation, not just in technology but also in how we finance innovative technologies and companies. As a consultant, I thrive on decoding these intricacies for you. Whether it’s understanding a SAFE or navigating the QSBS advantages, it’s crucial to grasp the potential returns and the underlying tax implications that could affect those returns.
Are you interested in delving deeper into how these financial vehicles affect your investments? Contact me, and let’s ensure your next move is not just bold but also brilliant.