Guest Post: The QSBS Implications of Managing VC Cash with Mutual Funds

How mutual funds can compromise QSBS status

Internal Revenue Code (IRC) §1202 outlines qualified small business stock rules. There are a few specific parameters that companies need to meet in order for any of their individual shareholders to qualify for this tax break. Those include:

• The shares being issued by a domestic C-corporation
• The corporation’s gross assets not exceeding $50 million immediately before or after the stock is issued
• The corporation operating in an industry not specifically excluded by §1202(e)(3) — excluded industries include health, engineering, architecture, and accounting services; farming; mining; and more
• Meeting the active business requirement set forth in §1202(e)(1)

That last part is what can make trouble for corporations that want to tap into QSBS tax advantages while also investing in mutual funds

A closer look at the active business requirement under QSBS

§1202(e)(1)(A) says that a corporation can meet its requirements only when “at least 80% (by value) of the assets of such corporation are used by such corporation in the active conduct of one or more qualified trades or businesses.”

When Congress created the QSBS categorization, the goal was to drive investment in small businesses with the intention of helping them grow. The thinking goes, then, that your business needs to be actively using its resources to propel that growth. In addition, under IRC §1202(e)(5)(B), a company can’t have more than 10% of its assets in stocks or securities of other businesses (like mutual funds) without losing QSBS status. Keeping any outside investments under that 10% cap helps ensure you meet the active-business test and preserve your QSBS benefits.

Putting more than 10% of your assets into any long-term holding - including an investment like a mutual fund - can disqualify your shares from QSBS eligibility. 

Does that mean that you have to simply park your cash in a bank account where it will see measly returns? Not necessarily. 

Fortunately, 1202(e)(6) - the working capital section - offers you some wiggle room here. It clarifies, “For purposes of paragraph (1)(A), any assets which… are held for investment and are reasonably expected to be used within two 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.” 

In other words, you could put more than 10% of your assets into an investment vehicle like a mutual fund. But you need to have a plan to move that money out and use it for business activities within a couple of years. 

Short-term mutual funds and QSBS eligibility

Traditional holding periods for mutual funds put them out of alignment with QSBS criteria. But there are some options that allow you to tap into the diversification and convenience of this investment vehicle. Specifically, if you want to leverage a mutual fund but preserve QSBS eligibility, look for short-term options.

Take, for example, Morgan Stanley’s Ultra‑Short Income Portfolio (MULSX). Because it centers on short-term instruments (e.g., corporate notes, CDs, repos), it can yield returns even if you don’t plan to keep your money there long. 

Some other mutual funds with short target maturities include the JPMorgan Ultra-Short Income Fund (JPST) and the Fidelity Conservative Income Bond Fund (FCONX). 

By putting your company’s money in a mutual fund that’s specifically designed for short-term investment, you should be able to avoid raising any red flags with the IRS. 

That said, it can still raise an eyebrow from an auditor. If you’re going to go this route, it’s important to take some steps to protect your company - and your and your investors’ QSBS eligibility. 

Best practices when using mutual funds and issuing QSBS

If an auditor does end up looking at your books and determining if you can offer QSBS status to your shareholders, having proof of a few things can be a big help:

• Regular money movement: Keep company money in mutual fund accounts for months, not years. Whenever money is deposited into a passive income vehicle like a mutual fund, have a clear plan to revisit it at a definite time. You might schedule a meeting with your finance team six months after making the initial investment to reevaluate it, for example. 
• A clear plan: Document where you’re putting the money and why. Have supporting documentation in place (e.g., your P&L forecast) to demonstrate why your business decided to put the money in a mutual fund instead of keeping it liquid and more readily available. 
• Maintenance of 80% assets ready for active business use: To be as safe as possible here, it’s best practice to keep less than 20% of your company’s money anywhere it will passively generate revenue. Having 80% or more of your assets readily available for active business uses shows the IRS that you’re committed to growing your company. That makes them more likely to greenlight your shares for QSBS eligibility. 

The more you can show an auditor to demonstrate that the mutual fund was a short-term, strategic investment, the easier it will be to stay QSBS eligible. 

Generating revenue while protecting QSBS status

Your company shouldn’t have to choose between keeping its shares eligible for QSBS tax treatment and generating returns on its cash. Short-term mutual funds are only one option to explore here. T-Bills could give you a safer, easier alternative, for example.  

If you want to learn more about using mutual funds and/or T-Bills strategically, reach out to our team. If you want to talk in more detail about QSBS eligibility to make sure you protect it for your company’s investors, contact our accounting partners at ShayCPA.