Guest post: The QSBS Implications of Managing VC Cash with T-Bills

Incentivizing investment with tax breaks

IRC §1202 outlines how gains from QSBS can be exempted from federal capital gains tax. Under the latest amendment, any qualifying stock that your small business issues today can potentially get a capital gains tax exclusion of 100%. 

This tax perk applies to individual taxpayers — i.e., founders, early employees, and angel investors, not VC funds — and represents a huge chunk of savings for them. The goal of this portion of the tax code is to encourage individual investments in U.S. businesses. Since these benefits can apply to you, they’re worth monitoring. 

To be eligible for the 100% capital gains exemption, the stock needs to come from a domestic C-corporation that had $50 million or less in assets at the time of issuance. The shareholder also needs to hold the stock for five years before selling it. 

But all of the onus to comply with Section 1202 rules isn’t just on the individual taxpayer. Your business also needs to do certain things to ensure they can claim this tax advantage. 

Specifically, per Section 1202(e), the corporation issuing the stock needs to use at least 80% of its assets for “the active conduct of 1 or more qualified trades or businesses.” 

That, then, begs the question: is parking that money in an investment tool like T-Bills considered actively conducting your business? 

Learning more about qualifying small business stock

IRC §1202 lays out specific requirements around which corporations and which shareholders can be eligible for this exemption. Businesses in certain categories — like financial services, farming, and hospitality — are excluded, for example.

To learn more about QSBS qualification, check out this guide we created at ShayCPA. 

The 80% rule: How IRC §1202 affects your options 

IRC §1202(e) was implemented to prevent founders from essentially becoming day traders. Without it, you could theoretically fundraise a bunch of money, then park it in various accounts as you collected interest and gains on any growth. To prevent that, the IRS uses this section of the IRC to ensure that companies are using the money they’re getting from investors (and company profits) to grow their business. 

IRC §1202(e) stipulates that “at least 80 percent (by value) of the assets of such corporation are used by such corporation in the active conduct of 1 or more qualified trades or businesses.” This 80% rule precludes you from being able to invest more than 20% of your company’s total assets long-term in an effort to collect passive income. 

The key word there, though, is “long-term.” Depending on the specific situation that applies to your business, you may be able to exceed the 20% benchmark. The differentiator is that you need to have a plan to use that money in active business undertakings within two years. 

The timeline component of QSBS eligibility

Under IRC §1202(e), there’s a subsection (6) that adds some clarity here. Per that portion of the code, any assets that are “held for investment and are reasonably expected to be used within 2 years to finance research and experimentation in a qualified trade or business or increases in working capital needs of a qualified trade or business shall be treated as used in the active conduct of a qualified trade or business.”

That’s a long way of saying this: if you have plans to use that money in the next 24 months, you’re safe to deposit it into an investment vehicle. Doing so won’t impact your, your team, or your investors’ QSBS eligibility.

That means you can put the money you don’t need just yet into a money market fund or invest it in T-Bills, for example. 

If you go the money market fund route, work closely with your accountant. IRC §1202(e)(5) puts a 10% cap on how much you can invest in the stocks and securities of other corporations. 

Whichever route you choose to invest financial capital, you need to do two things to protect your QSBS eligibility:

• Have a plan to actively use that money in the business within two years
• Have documentation to back up that plan

Documenting your plan to protect your QSBS eligibility

If you need to show the IRS documentation to prove that your corporation meets QSBS requirements, you want to be able to show that you had both a concrete timeline and a definite use planned for the money.

If you’re scaling up your team, for example, set milestones about who you will hire at which benchmark (e.g., fractional CFO in six months, full-time CFO in 18 months). Make sure that’s clearly documented somewhere. 

One way to document this is to have a detailed Financial Model that clearly lays out how funds will be deployed in the next 24–36 months. Founders frequently use financial models to help them raise capital and budget early on. 

When building that financial model, work with your finance team to analyze your inputs, assumptions, and cash flow projections with an eye on how they will impact your QSBS status. After your financial model is created, Budget vs Actuals P&L reports can act as additional substantiation. These can further defend the assumptions you made and can be regularly tracked by your finance team. 

This documentation doesn’t necessarily lock you into a stated timeline, either. If a company starts turning a profit sooner than expected, it can allocate that toward payroll rather than pulling from its T-Bill treasury account, for example. Adapt your financial model, though, to show your growth and your new plan to use parked funds within two years. 

In short, you want to be able to show the IRS that you’re temporarily holding money in passive accounts, and that it’s ultimately earmarked for actively supporting the business. 

To date, there are no large-scale court cases we can turn to for guidance around what documentation is needed. To protect your company’s QSBS status, be as thorough and clear as possible. If you do end up facing the IRS, you want to be able to show there was a definite plan to deploy that capital — and that the money wasn’t merely parked in T-Bills or elsewhere to passively generate returns. 

To explore leveraging T-Bill investments to extend your runway, reach out to Rho's team. And to explore your company’s QSBS eligibility and steps you can take to protect it, contact our team of accounting partners at ShayCPA.