Are simple agreements for future equity (SAFEs) considered qualified small business stock (QSBS)? Surprisingly, or maybe not surprisingly, the IRS doesn’t know, or won’t tell you. The safe (pun intended) answer is that, generally, no, a SAFE is not QSBS.
Section 1202 of the Internal Revenue Code states that QSBS means stock in a C corporation that is originally issued after August 10, 1993, if, at issuance, the corporation is a qualified small business and the taxpayer acquires the stock at original issue in exchange for money, property other than stock, or services. While the actual reporting of the sale of QSBS is relatively straightforward, there are a number of very technical hurdles to test whether stock is QSBS before and after it is acquired, so ongoing maintenance of the qualification is paramount, and very likely not a DIY job.
One common question that founders and investors in startups ask is whether SAFEs qualify as QSBS? Its certainly a fair question as SAFEs are the absolute standard for early-stage investments in software and tech. If you are unfamiliar with SAFEs, they were invented by the startup accelerator Y Combinator in 2013. SAFEs were designed to make it easy for investors and founders to agree on funding startups in the pre-seed and seed stage without agreeing on a value now and saving tons in legal fees for drafting agreements.
For tax purposes, a SAFE can potentially be characterized as one of several different instruments: an option or warrant, a forward contract, equity, or debt. As you can imagine, each of these different asset classes can have different tax treatment. The most plausible treatments that could be argued are that SAFEs more closely align with forward contracts or equity, but the IRS has not ruled on SAFEs for QSBS, and more broadly, the IRS has hardly ruled on QSBS!
Tony Nitti, a National Tax Partner at EY and one of the foremost experts on QSBS, has said of the lack of case law that QSBS is a massive tax benefit operating in a virtual “case law vacuum.” Tax advisors have only a few tax court cases that address or partially address QSBS, which leaves a handful of private letter rulings (PLRs) to read to understand how the IRS views certain aspects of QSBS. The problem with PLRs is that they are not precedent that can be relied upon except for the taxpayer who requested it (and paid a great sum of money).
Due to the lack of any certainty around SAFEs, prudent taxpayers should not consider their holding period of QSBS to begin when a SAFE is executed. For the majority of stock received before July 5, 2025, the QSBS holding period is five years. For stock received on or after July 5, 2025, there is a tiered holding period:
- 3 years: 50% exclusion
- 4 years: 75% exclusion
- 5 years or more: 100% exclusion
Aside from broken estate-planning or rollover planning, if a taxpayer misjudges their QSBS holding period due to using SAFEs and assuming the SAFE started the clock for QSBS, there could be steep tax consequences. If the SAFEs holding period cannot be defended against an IRS examination, the taxpayer could face tax on the gain that should have been recognized, interest, and potentially a 20 percent Section 6662 penalty.
If you are an investor using SAFEs to make investments and plan to employ QSBS, diligence should be performed with tax and legal counsel to make sure the instrument qualifies, as QSBS and SAFEs are highly technical.
Sync CPA is a licensed Colorado CPA based in the Denver metro area but serving clients throughout the United States. Please use my Contact page to discuss your tax situation with Sync CPA.
