100% Exclusion for Qualified Small Business Stock To Be Extended

Big news: On December 16, 2014, the Senate passed H.R. 5771, the Tax Increase Prevention Act of 2014. The bill now goes to the President. He is expected to sign it.

The bill would do a variety of things, but from a startup perspective one important thing it would do is renew the 100% exclusion from tax for gain on qualified small business stock received from qualifying C corporations during the calendar year 2014.

Qualified Small Business Stock

The 100% exclusion expired at the end of 2013. This bill renews the 100% exclusion for stock issued by qualifying C corporations issued before the end of 2014.

Thus, if:

  1. You received founder shares in a C corporation in 2014, or
  2. You invested in shares of a C corporation in 2014, and
  3. You hold those shares for 5 years,
  4. You may be able to exclude up to $10M in gain from the sale of those shares.
  5. There are a variety of other limitations that apply to the Section 1202 qualified small business stock benefit. For example, the corporation issuing the shares has to, among other things, be a “qualified small business,” have less than $50M in gross assets, have an active business, and be engaged in a qualified trade or business.

The Text of the Extension

1202

This 100% exclusion affects your choice of entity considerations significantly. Only C corporations can issue qualified small business stock. Thus, if you form an S corporation, your founder shares cannot qualify for the 100% exclusion.

The Cap on the Benefit

The 100% is not uncapped, but you can exclude up to $10M under Section 1202.

limitation

In Conclusion

This extension is good news for the startup world.

Crowdfunding Advertising in the Intrastate Crowdfunding Context

Suppose you want to run a crowdfunding offering for equity in Washington State. Suppose you have filed your Crowdfunding Form with the DFI and it has approved of your offering.

Crowdfunding Advertising

Can you advertise the offering?

There are multiple layers to the analysis.

First you have to comply with the Washington law. The Washington law requires that the DFI first approve of your advertising.

When you submit your Crowdfunding Form, you also have to submit a “copy of all advertising and other materials directed to or to be furnished to investors in this offering.” WAC 460-99C-040.

In addition, WAC 460-99C-250 requires the following with respect to advertising:

(1) All advertising directed to or to be furnished to investors in an offering under RCW 21.20.880 shall be filed with the director no later than seven days prior to publication or distribution.
(2) The following forms and types of advertising are permitted without the necessity for filing or prior authorization by the administrator, unless specifically prohibited.
(a) So-called “tombstone” advertising, containing no more than the following information:
(i) Name and address of issuer;
(ii) Identity or title of security;
(iii) Per unit offering price, number of shares and amount of offering;
(iv) Brief, general description of business;
(v) Name and address of broker-dealer or underwriter, or address where offering circular or prospectus can be obtained; and
(vi) Date of issuance.
(b) Dividend notices, proxy statements and reports to shareholders, including periodic financial reports.
(c) Sales literature, advertising or market letters prepared in conformity with the applicable regulations and in compliance with the filing requirements of the SEC, FINRA, or an approved securities exchange.
So, under Washington law, it is possible to advertise your offering.

What about federal law?

Federal law imposes more limitation on advertising crowdfunding offerings. You can find the SEC guidance at the following links:
This guidance generally prohibits the unrestricted posting of crowdfunding advertising on the Internet. However, the guidance allows you to post to web sites if you restrict viewers to residents of the state.

Question: Can an issuer use its own website or social media presence to offer securities in a manner consistent with Rule 147?

Answer: Issuers generally use their websites and social media presence to advertise their market presence in a broad and open manner so that information is widely disseminated to any member of the general public. Although whether a particular communication is an “offer” of securities will depend on all of the facts and circumstances, using such established Internet presence to convey information about specific investment opportunities would likely involve offers to residents outside the particular state in which the issuer did business.

We believe, however, that issuers could implement technological measures to limit communications that are offers only to those persons whose Internet Protocol, or IP, address originates from a particular state or territory and prevent any offers to be made to persons whose IP address originates in other states or territories. Offers should include disclaimers and restrictive legends making it clear that the offering is limited to residents of the relevant state under applicable law. Issuers must comply with all other conditions of Rule 147, including that sales may only be made to residents of the same state as the issuer. [October 2, 2014]

This advice from the SEC is very helpful. Thus, you can advertise your offering, if you follow these rules. But you will want to be extremely careful to follow this advice and not inadvertently advertise your offering more broadly on the Internet.

Rethinking Section 3(a)(11) for State Crowdfunding

Section 3a11Guest post by Andrew Stephenson of CrowdCheck.

Over the past few months, Anthony Zeoli, Georgia Quinn, and CrowdCheck have been maintaining a chart of existing and proposed state crowdfunding statutes and rules. These state crowdfunding rules all follow a typical model:

  • Short form registration at the state level;
  • Issuers must comply with Section 3(a)(11) of the Securities Act and Rule 147;
  • Issuers must provide basic information about the company, risk factors, and material information to investors; and
  • General solicitation is permitted.

Statues like this have been in effect since Georgia and Kansas first enacted their crowdfunding rules in 2011, and ten other states have adopted similar rules. However, since 2011 only a handful of issuers have actually utilized these rules. For statutes that purport to provide “entrepreneurs with expanded access to much needed capital,” there is not much access to capital that is occurring. Still, even with clear evidence that there has not been uptake of state crowdfunding under these rules, state legislators are still under the belief that Section 3(a)(11) is the proper federal standard for state crowdfunding.

The primary reason that issuers are not using these state crowdfunding rules is the inherent limitations of the intrastate offering. Section 3(a)(11) has always been understood to be an exemption for securities offerings that are genuinely local in character. Not only must the issuer be registered and doing business in the state where it is making an offering, the securities may not be offered or sold to residents of other states. As we know, “offer” is a very broad terms that includes any attempt to sell the security, or to condition the market or arouse interest.

As such, a bootstrapping start-up that posts to Twitter that it is looking for funding has now lost the availability of the Section 3(a)(11) exemption, and may even be found to have violated Section 5 of the Securities Act—an enumerated Bad Act that could prevent the company from being able to access capital under Rule 506, and the to-be adopted Regulation A+ and federal securities crowdfunding.

That is a lot of damage from one little Tweet. No wonder very few issuers have taken advantage of these rules.

Maine, however, has taken a different course. The bill initially proposed for state crowdfunding in Maine followed the Section 3(a)(11) standard. However, in committee, the bill was changed to fit within the small offering exemption of Rule 504, specifically for the purpose of allowing solicitation methods that include social media and the internet. This is the model that states should follow if they want to make crowdfunding successful in their states.

One thing that is different about Rule 504 is that in order to engage in general solicitation, a substantive disclosure document must be filed with a state and be provided to investors. Previously, the SEC has indicated that the NASAA U-7 Form would suffice. While the disclosure requirements of the U-7 are significant, they are not impossible to comply with. Entrepreneurs with a good understanding of their own business should be able to complete the disclosures with minimal assistance from legal counsel (and I would never advise an entrepreneur to engage in any form of capital-raising without the assistance of counsel).

The switch to Rule 504 and the substantive disclosure requirement will be easy for some states that have already adopted a disclosure document for their state crowdfunding rules relying on Section 3(a)(11). For instance, the State of Washington and the District of Columbia have adopted a disclosure form that is slightly pared down from the U-7. These disclosure documents would likely satisfy the SEC’s standard for “substantive” disclosure.

States that are truly interested in providing rules by which entrepreneurs can raise money in a crowdfunding campaign would be smart to focus on the federal exemption under Rule 504. Section 3(a)(11) just doesn’t work.

QUICK COMPARISON

Chart

The Trouble with State Crowdfunding

Thirteen states have now enacted state crowdfunding laws. Twelve of these state laws have been built on Section 3(a)(11) of the federal Securities Act of 1933. The only exception is Maine, which built its law on Rule 504. See this great table put together by Anthony Zeoli.

The Troubles with State Crowdfunding

The trouble with state crowdfunding laws is that they have to comply with the strictures of Section 3(a)(11) (ignoring Maine for a minute). In other words, the problem with these state laws is that the federal law is too restrictive!

Section 3(a)(11) exempts from the federal act the following types of offerings:

Any security which is a part of an issue offered and sold only to persons resident within a single State or Territory, where the issuer of such security is a person resident and doing business within or, if a corporation, incorporated by and doing business within, such State or Territory.

The SEC has adopted a rule, Rule 147, interpreting Section 3(a)(11). And the SEC has issued interpretive guidance on Section 3(a)(11) offerings.

The SEC guidance crimps the usefulness of Section 3(a)(11). For example:

  • Under Rule 147, issuers have to meet a variety of 80% tests in order to be considered intrastate.
  • Under SEC guidance, companies conducting an intrastate crowdfunding campaign can’t advertise on the unrestricted Internet–because that would be considered an offer across state lines.

Rule 504 Is Better

Under federal Rule 504, an offering can involve general solicitation if the offering has been registered in the states in which the offering is made. Section 502(c) is the advertising limitation, and it is expressly carved out from coverage for state registered offerings under Rule 504. I have quoted the relevant provision of Rule 504 below.

Rule 504

Maine has structured its crowdfunding rule as a registration so that such offerings can be made in reliance on federal Rule 504.

State registered offerings under Rule 504 are not be subject to the 80% rules or intrastate advertising limitations of Rule 147. States should consider minor modifications to their laws built on 3(a)(11) to take advantage of federal Rule 504.