In episode 61 of How Tax Works, Matt Foreman discusses Simple Agreements for Future Equity (SAFE), the debt-like and equity-adjacent agreement that could, maybe, perhaps be equity in certain circumstances.

Register for the Advanced Tax Strategy Series here.

Listen to the episode here:

  

Follow us on Bluesky: @howtaxworks.bsky.social

How Tax Works, hosted by FRB Partner Matthew E. Foreman, Esq., LL.M., delves into the intricacies of taxation, breaking down complex concepts for a clearer understanding of how tax laws impact your financial decisions. Through this, listeners are treated to a comprehensive breakdown of entity structures, from the robust shield of C corporations to the flexibility of partnerships and LLCs. Foreman navigates through the maze of tax considerations, shedding light on entity-level taxation, shareholder responsibilities, and nuanced tax strategies. Foreman shares valuable insights and practical advice, emphasizing the need for informed decision-making and consultation with tax professionals. From qualified small business stock to state and local tax considerations, no stone is left unturned in this illuminating exploration of tax law and entity selection.

Whether you’re a seasoned entrepreneur, accountant, lawyer, or financial advisor, How Tax Works offers a wealth of knowledge to empower you in making sound business decisions. Tune in and embark on a journey to unravel the complexities of tax law, one episode at a time.

This podcast may be considered attorney advertising. This podcast is not presented for purposes of legal advice or for providing a legal opinion. Before any of the presenting attorneys can provide legal advice to any person or entity, and before an attorney-client relationship is formed, that attorney must have a signed fee agreement with a client setting forth the firm’s scope of representation and the fees that will be charged.

Transcript:

**This transcript has been prepared automatically by AI and may contain inaccuracies**

Matthew Foreman [00:00:09]:
Hello and welcome to the 61st episode of How Tax Works. I’m Matt Foreman. In this episode, I’ll discuss qualified small business stock and simple agreements for future equity, or as tax professionals call them, QSBS and SAFEs. This is, this is actually my 6th time talking about QSBS, and I assure you it will not be the last. How Tax Works is meant for informational and entertainment purposes only. It may be attorney advertising, and it is not legal advice. Please hire your own attorney. How Tax Works is intended to help listeners navigate the intricacies and complexities of tax law, regulations, case law, and guidance to demystify how taxes shape the financial and and business decisions that we all make sometimes unknowingly.

Matthew Foreman [00:00:54]:
A few things, you know, new episodes every 2 weeks. The next one will be comments that tax lawyers overhear while on vacation. I don’t, I don’t, I don’t know. People say stuff and you overhear it and it’s like, there’s a great bit by Lewis Black that involves from The White Album, which I think was his first album, and it involves the phrase, If it weren’t for my horse, I wouldn’t have spent that year in college. And what I’ve learned is that as a professional, when you hear something that like involves you as a professional and what you do, it makes you stop and your mind kind of grinds. So I want to talk about that, and it’s a lot of misnomers. I have 6 free webinars coming up. They, they start in November, they run through December.

Matthew Foreman [00:01:42]:
They are every Tuesday, I think from— I’m clicking on my calendar now to see. Yeah, they’re from— yeah, they’re from 1 to 2 o’clock every Tuesday, November 3rd. I don’t do one the week of Thanksgiving, so I do 3, then take a little break, and then 3 more. The topics are passive activity loss rules under Section 469, selling a business, which is tax and non-tax, sole proprietor, capital partners, and payroll taxes. Opportunity Zone 2.0, a QSBS update, because I talk about it way too much, so why not? And equity incentives. So those, you can go, look, if you go to the FRB page for How Tax Works, you can find it, you can sign up. They’re free continuing ed for attorneys, CPA, enrolled agent, and CFPs. If you can’t find it, email me and I will direct you to it.

Matthew Foreman [00:02:36]:
So it should be easy. So one question that I get once a month, maybe every 2 or 3 months, definitely once a quarter, is whether a SAFE or the equity received when a SAFE converts is eligible for QSBS and when. I get it often. Often wealth managers, you know, CFPs and other related things, there’s other people sort of in that space. Often they’re the ones who ask the question because they had a client who asked, and I’m like, well, you know, it kind of depends. But before we get there, you know, what is a SAFE? I talked about a SAFE earlier in my, in my podcast. I want to say it’s like episode like 8 or something like that. I’m, I’m currently scrolling.

Matthew Foreman [00:03:22]:
I’m currently delaying so that I can find the answer. The answer is— Yeah, episode 8. Wow. Just sort of threw it out there. I talk about convertible debt and SAFEs, but I talk about what a SAFE is, Simple Agreement for Future Equity. It’s interesting. I talk— I’m going to talk about, you know, what is a SAFE and what does this thing mean? Pre-money, post-money, you know, stuff like that. I’m going to talk about those later.

Matthew Foreman [00:03:47]:
So just sort of hold on on that one. But a SAFE is sort of this weird world. It’s not equity. It’s not debt. It’s probably accurately a prepaid forward contract, but because tax is strange, it’s strange. It has weird things. Stuff comes up that creates sort of strange situations, and QSBS is one of them. A SAFE, you know, used to all be pre-money.

Matthew Foreman [00:04:10]:
Now they can be what’s called pre-money and post-money. Like I said, I’ll talk about that later. And the issue is that makes this a challenging question is that it’s neither equity nor debt. necessarily. However, you know, it’s likely equity for 382 purposes, which is net operating loss limitations on sale, or 383 actually too. Same, same basic thing, but for credits. It’s debt for 351 purposes. I think that’s 351.

Matthew Foreman [00:04:38]:
So for certain purposes, you know, it is equity, it is debt, but for general tax purposes, it may actually be neither. Maybe both, maybe one. And generally speaking, no one really knows. I’m not trying to sound flippant, but no one entirely knows what QSBS— excuse me, what a SAFE is for equity or debt purposes, whether it’s one or the other. Anyone who tells you that it’s absolutely X is either doing it based specifically on your specific SAFE because they are often modified and things like that. Or they’re just kind of wrong. Not trying to sound rude, but, you know, some people just like, oh, it’s definitely X. And I’m like, you know, it depends.

Matthew Foreman [00:05:21]:
Second point is, you know, what is QSBS, Qualified Small Business stock? I talk about this 6 previous episodes, 5 previous episodes, 6th time, as I noted. It’s episodes 17 through 19 kind of define what it is. It’s a big topic. There’s a lot of detail. I also talk about it in episodes 38, 44, and 52. This is 60. 2021, by the way. Kind of crazy.

Matthew Foreman [00:05:40]:
I feel like a little going back to ’98 with Mark McGwire. But anyway, the key for QSBS is what’s called the original issuance requirement, which is basically when did the shareholder receive stock? Receive it. It must be stock, not just a SAFE. So receiving the SAFE itself does not start it, which is what we’ll get into in more detail, I promise. And That’s unless the SAFE for income tax purposes is considered stock. This may sound weird, but sometimes something called equity, such as stock or an LLC membership interest, is actually debt for tax purposes. And sometimes something called debt is actually equity. Convertible debt, right? Called debt, but if it has rights to dividends or the dividends are kind of like held back for them so that eventually later they’ll get their dividends, Or there’s voting.

Matthew Foreman [00:06:32]:
Convertible debt can have voting under certain circumstances. This is why, you know, I get these conversations. People are like, oh, you know, I have my preferred shares. And I’m like, well, what does that mean? And they’re like, oh, they’re preferred shares. And, you know, I prefer if you didn’t just sort of use the term, right? You know, preferred equity can be a lot like debt, right? So, you know, equity in a preferred that has a fixed return doesn’t have tremendous voting, a little bit, but can’t really affect anything. Nothing else. Well, that’s a lot more like debt. So debt can be equity, equity can be debt.

Matthew Foreman [00:07:02]:
So I think that that’s an important point. So don’t hold yourself too closely for what it’s called. It’s about the substance. This is, this is a real, you know, humdinger of an economic substance thing. But the crux is that, you know, the analysis under Section 385 is where you go, which, which is Congress is, I’ll say lazy. I don’t want to use the word incompetent. That’s that’s too mean, but their lazy attempt to determine whether certain interests in a corporation should be treated as stock, which is equity, or indebtedness, which is debt. Theoretically, an LLC can be taxed as a C corp.

Matthew Foreman [00:07:36]:
So for this point, you know, I’m going to keep talking about stock, but I really mean equity. It’s— that’s all it is. If you have LLC interest but it’s taxed as C corp, tax lawyers, tax accountants shouldn’t call it an LLC membership interest. They should call it stock because that’s That’s what it is for tax purposes. It’s really, you know, 385 is really just a delegation of authority for the Treasury or IRS to draft regulations. They did, I think it was under the second Obama administration, his second term, but it was pulled back amid criticism, most of which was correct. I thought it was a little aggressive, but you know, here, here we are. So, you know, there’s no real law.

Matthew Foreman [00:08:14]:
It’s, here are some factors and that’s it. But it’s important to remember that, and this is where it’s important, right? A pre-money SAFE was the original SAFE. It’s the first thing that existed, and it is the cash for the SAFE, right? And then eventually you get equity if it triggered. The number of shares that you get dependent upon the valuation cap, discount, or both. There’s no interest rate, no maturity date, no voting, no dividends, nothing that resembles equity. So it’s almost certainly pre-money SAFE. Is definitely, is almost certainly not equity. This is the original.

Matthew Foreman [00:08:47]:
Really what it was was, hey, if we do evaluate, you know, if we do a cash raise or we do a sale over X value, you get, you know, you get some number of shares, right? However much you’d buy for X dollars, you get a discount. Often it’s pretty good, 30%. So it’s a real thing, but you know how much you got depended on it. The more common one is now what’s called a post-money SAFE. It was introduced when Y Combinator sort of pushed out more versions of the SAFE in 2018. And it basically said you get an ownership percentage after the event that triggers the SAFE to become equity, SAFE to become stock. Sometimes, you know, there are ones that participate in dividends. There are SAFEs that says that parties intend for the SAFE to be characterized as equity.

Matthew Foreman [00:09:32]:
And I just want to make one thing clear, and we’re going to get a little music in. But, you know, simply because parties agree to tax characterization is not binding on the IRS or any state revenue agency. It shows intent. You still have to be consistent with it. But, you know, a rose is, you know, rose with any other name would smell just as sweet. So I think that’s important to understand that simply because you agree how it should be taxed or how it should be viewed, you still have to have the actual economic underlying economic substance to be it, you know, and that’s important. All right. Let’s get some music in.

Matthew Foreman [00:10:05]:
And then we’re going to talk about, try to, try to break down whether a SAFE is debt or it is equity. Okay, we’re back. So the question is under 385, right? How much authority is there? And the answer is not much. 385 gives 5 factors. There’s, you know, whether something is debt or equity. This is not— we’re not really talking about what a SAFE is here. We’re talking about just how do you generally decide what is debt or equity? Okay. And then I’ll apply it, you know, after I do this.

Matthew Foreman [00:11:00]:
So 385. 5 factors. One, written promise to pay on demand or on a date. Date has to be fixed. Subordination or preference over any debt, right? Because that’s how it works. Debt has sort of a stack, then you hit the equity. Ratio of debt to equity generally, right? If you are a company with like 1 share and $400 trillion of debt, your debt may not actually be debt. It might be equity.

Matthew Foreman [00:11:24]:
Whether it is convertible into stock of a corporation. Believe it or not, being convertible debt could be suggestive that it’s actually equity. And the relationship between the holdings of stock and the holdings that is issued. So if you buy something that purports to be debt and you acquire it at the same time, you’re also buying stock and they’re kind of similar, you might just have bought more stock. It depends, right? So then there’s Treasury Regulation 1.385-1, which says that unless there is a specific rule, use common law. People often use, you know, it says, hey, you know, use Mixon, which is State of Mixon, 464, Fed. 2nd, 394. It’s a 5th Circuit case from the ’70s.

Matthew Foreman [00:12:04]:
There are 13, 1-3 factors in Mixon. So good luck. They don’t ever really tell in any of these factors which ones are most important or how to weigh them. I think that’s kind of intentional. Candidly, I think it’s one of those ones where you don’t really want to overly think about it. Just sort of look at the totality. But some I think are more obviously important. The 13 factors are names given to whatever you bought, debt or equity, the presence or absence of a fixed maturity date, the source of payments.

Matthew Foreman [00:12:44]:
That was 3. 4, right to enforce payment. Of principal and interest. 5, participation in management. 6, subordination. 7, intent of the parties. 8, thin or adequate capitalization. 9, identity of the interest between the creditor and stockholder.

Matthew Foreman [00:12:59]:
10, payment of interest only out of dividend money. So basically, if they’re like, oh, if money’s available, then we’ll pay, well, that suggests that it’s equity, not debt, right? 11, ability of corporation to obtain loans from outside lending institutions. So could this be debt if weren’t an insider, often the question there. 12, the extent to which the advance was used to acquire capital assets. And 13, 13, final one, lucky 13, the failure of the debtor to repay on a due date or seek a postponement. So if it’s, you know, 1 and they’re just, they don’t pay and payments weren’t made and nothing happens, well, that kind of smells like equity, doesn’t it? Right. So I think that that’s a really important one. Finally, there’s also the IRS pushed out Notice 9447, which is sub-regulatory guidance.

Matthew Foreman [00:13:42]:
Very little, very little authority to it, but it’s something to do. And there’s 8 factors there that I think are important. Okay. Those factors are: 1, whether there’s an unconditional promise on the part of the issuer to pay a sum certain on demand or at a fixed maturity date. 2, whether holders possess the right to enforce payment of principal and interest. 3, whether the rights of holders are subordinate to the general creditors. That was 3. 4, whether the instruments give holders the right to participate in management of the issuer.

Matthew Foreman [00:14:14]:
That’s voting for those scoring at home. 5, whether the issuer is thinly capitalized or properly capitalized. 6, whether there is an identity between the holders of the instruments and the stockholders of the issuer. If it’s all the same people holding the same stuff, it’s suggestive that it’s equity because it doesn’t really change the stack a lot. A lot of big stuff between debt and equity is changing who gets money first if the company goes bankrupt. Because debt holders get paid first, right, in the event of bankruptcy or otherwise insolvency. 7, label placed on the instrument or instruments by the parties. So that’s important.

Matthew Foreman [00:14:45]:
What do you call it does matter, but not a whole lot. 8, finally, whether the instruments are intended to be treated as debt or equity for non-tax purposes. How do you look at it? What does it say it is? Other people will say, well, look, the agreement says that it’s equity, but we want to call it debt for tax purposes. You can. Got to look at it. So what is a SAFE? Let’s apply all those factors. Okay. A debt, you know, look, if a SAFE is considered debt, then it can’t be QSBS.

Matthew Foreman [00:15:13]:
QSBS, Qualified Small Business Stock. Debt cannot be stock. That’s pretty obvious. 351, I think I said earlier, but I think it’s actually . SAFEs are debt for 351 purposes, but the lack of fixed maturity date, stated interest, even if the interest is kind of implied, obligation to repay or the creditor remedies such as foreclosure, that really suggests that it’s not in fact debt. Debt is pretty, you know, pretty fixed. So that’s important. So it smells more like what a lot of people call preferred equity, which is equity with a bit like a little benefit, a little kick on top.

Matthew Foreman [00:15:50]:
You know, I talked about a variable prepaid forward contract, which is basically you pay a fixed amount of cash now, And upon an event, you get X cash back or something else, right? So the corp, you get equity, you get the stock at a future date upon a triggering event that’s fixed or pegged to a number of shares, specific number. That’s for post-money. We’re only talking about post-money. Pre-money, pre-money SAFEs, they’re not equity, so don’t worry about it. It’s really an open contract under the open contract doctrine. It becomes not taxable upon conversion of the triggering event. So basically, It’s an open transaction. Then once it triggers, it’s not taxable under— I want to say it’s 1032.

Matthew Foreman [00:16:32]:
If my memory serves me right, there’s a section of the code that says that a company can sell its own equity, LLC, corporation, whatever, without tax consequences. And that’s why it’s not taxable. So you keep the transaction open until it happens. You know, if it never triggers, then the SAFE itself might actually be taxable to the recipient. It’s not really relevant here. I’ve had people sort of ask the question, is it? And I’m like, it could be, could be, because they did get equity. They did charge money for something and never hit actually granted the equity. So kind of interesting.

Matthew Foreman [00:17:05]:
So if— what is a prepaid variable contract, right? If it is a prepaid variable forward contract, it’s not QSBS, so it must not be debt, must not, you know, or a prepaid variable forward contract, right? Because if you think It might be QSBS. It can’t be a prepaid variable forward contract. So, you know, what is it, right? Let’s say, well, let’s make the argument, right? Let’s say it is current equity right now. You buy the SAFE and it’s equity for QSBS purposes, right? Post-money SAFEs may have dividend rights. They may have liquidation rights. So it’s like non-participating preferred stock. You don’t get dividends, but you get liquidation rights. It may have fixed ownership percentage.

Matthew Foreman [00:17:46]:
Most most actually do. And some, you know, agreements actually have one where they agree on the tax consequences. They say this is equity for, you know, purposes of the Internal Revenue Code. Yeah, I mean, that’s a thing. And look, check the agreement. That’s a great— that can be a negotiating point. Sometimes the issuing company does not actually want to make it equity, or they kind of want to just say, you know, don’t worry about these. These are not the droids you’re looking for.

Matthew Foreman [00:18:14]:
But it depends, right? Some people will take the position that is safe in an S corp where you have different rights, right? In any way, that could be a second class of stock. So they’ll be like, this is not equity. We don’t know what this is, but it’s not equity. You know, I think an important case is Grote& McKay Realty, which is a Tax Court case from ’81, and Anschutz, if I’m pronouncing it right, which is a 10th Circuit case from 2011. And it talks about the benefits and burdens analysis. which is basically like the benefits and burdens of ownership and the benefits and burdens of debt. They’re different. They’re just different, right? The idea that a post-money SAFE could very well be current equity is also supported by the IRS’s PLR 2016-36003.

Matthew Foreman [00:18:56]:
And even though PLRs are not precedent, cannot be cited as precedent, it’s a challenge will be the word I use for the IRS to go the other way, to disagree with its own. It’s a stuff like that. Plus the PLR references Revenue Ruling 69-591, which obviously very much predates SAFEs. And it talks about how you need present rights of ownership, not just future rights. So if the SAFE has present rights of ownership, then you might, right? Voting rights are huge, huge, huge, huge, huge, huge. Even if just major decisions, right? Not hiring, not firing. But, you know, if you want to sell the company and the SAFE can stop it or the SAFE can force things, That matters. That’s really important.

Matthew Foreman [00:19:39]:
All right, let’s get a little music and then I’m going to bring it home. It’s a little longer of a conclusion than I tend to have, but I think it’s worth the time. So we’re back, but let’s come to some conclusions. Let’s just try to wrap this sucker up and actually answer a question. What is a SAFE? Is it QSBS? Pre-money SAFE? Nope. Post-money SAFE? Maybe. It depends. Possibly.

Matthew Foreman [00:20:46]:
I’d like to read the document. That’s my answer, right? So let’s look at it. But, you know, look at the document, see what it has. You know, you can do an opinion. I’ve been asked on them. You know, we’ll do an opinion on it. Depending on the factors, how comfortable we are, you know, with the answer, you can draft a memo. We can, we can analyze it and let’s, you know, let’s talk, right? Like Linda, Linda Richman said, let’s talk.

Matthew Foreman [00:21:06]:
No big whoop. But let’s talk about collateral issues. I actually think that the collateral issues with the SAFE QSBS question are so interesting because they’re like, man, they just, they just run out there and just like, oh, that’s a problem. Oh, that’s a problem. So one, do you have a $10 or $15 million exclusion? Well, so maybe you don’t want a SAFE to be QSBS because it’ll push you into the later, right? Depending on when you do it. So, you know, if you were granted on January 1st, 2025, this, or you purchased, excuse me, it could be granted a SAFE, but you purchased a SAFE on January 1st, 2025, you may want the larger exclusion. So you’re going to say, no, it’s not. We’re going to wait till it triggers.

Matthew Foreman [00:21:47]:
Same issue with $50 versus $75 million in gross assets. So I think that’s really important. Converse is holding period, right? Earlier holding period is better unless before it was 100% excluded. So let’s go back, right? You know, let’s say this, you bought the SAFE in 2009, which is impressive. SAFEs didn’t exist then, but you bought on January 1st. You know, it’s only a 50% exclusion, so you might actually want to wait until it triggers later to get the 100% exclusion. So that’s really important. Or like the 3, 4, 5, you know, I’ll talk about the 3, 4, 5 thing later.

Matthew Foreman [00:22:16]:
I don’t want to, I don’t want to hop ahead here. But the key really is, when is it equity? When does that happen? When does that matter? You know, there can also be an appreciation between the purchase of the SAFE and the trigger date, and that appreciation, right, is not excluded, but it could increase— that amount itself is not excluded, so it could increase your exclusion. At least I think so. You know, it’s unclear, but, you know, the whole thing is under 1202. I will at some point just do an entire episode on 1202 because the math is interesting. But let’s say you buy a SAFE for $100,000. It’s worth $2 million when it converts, right? The gain between the $2 million and the $100,000, that $1.9 million. So first $100,000 is return of basis.

Matthew Foreman [00:23:02]:
Next $1.9 million, fully taxable. Then the next $20 million, right? Or, you know, the next $20 million is not taxable. You have a $20 million exclusion. So it may work out in your favor. It may not. It depends, as every lawyer says, right? The weird 3, 4, 5-year threshold in OB thrice, right? So you buy a SAFE on January 1st, 2025, is triggered on August 1st, 2027. You take the 5-year only, which is 2030. 1/1/2023 is when you hit 5-year because you’re saying, oh, it was— SAFE was QSBS initially.

Matthew Foreman [00:23:38]:
Or do you get the 3, 4, 5 year, right? Let’s say you sell, you know, a little earlier, you 3 years, maybe it’s $15 million excluded, but 50%. There’s some math there. It depends. Let’s say you sell it on January 2nd, 2030 for $10 million. And then the $15 million, you know, then at that point, right, you sold it for $10 million. The $15 million exclusion isn’t helpful. So you’d rather, you know, have a situation, right? So the 3, 4, 5 years isn’t full exclusion. So maybe you want to do a 1045 rollover.

Matthew Foreman [00:24:10]:
There’s other things like that. So the timing period really matters. If the SAFE, you know, if you have a SAFE, the next one, I’m sort of moving on from the 3, 4, 5-year threshold. I know I didn’t go into super detail, but that’s something just to watch out for, I think, is a challenge. But the next one is if a SAFE, if it’s a SAFE, but it’s not QSBS. It’s not present equity, right? You can contribute the SAFE to a partnership and that’s fine. And then the partners would all get, upon the triggering event conversion, would all get QSBS, right? But if a SAFE is QSBS, if you were to contribute to a partnership, you no longer have QSBS. So it can really matter.

Matthew Foreman [00:24:48]:
There’s really different things you can do. SAFEs are much cheaper for gifting and stacking because they’re not worth as much as the equity, right? QSBS only triggers Only converts, excuse me, SAFEs only trigger a convert when they’re worth more. You know, that’s the idea. 1045 rollover, I talk about it episode 19 a bunch, I think. But basically if the trigger is a sale, then there’s no QSBS, right? Because you go from a, you go from a SAFE immediately to your Q— to a— You go from a SAFE to QSBS and it’s QSBS eligible stock, but you have to hold the stock for at least 60 days for 1045 to get the rollover. So you might, may not do that. So that can be problematic. But if you sell a QSBS before 5 years, can you buy a SAFE? I had someone ask that maybe 2 weeks ago, 3 weeks ago.

Matthew Foreman [00:25:32]:
So if the SAFE is QSBS and you can roll over into the SAFE because it is QSBS, I tell people just use non-voting stock that auto converts to other stock. That way it’s equity from the start. Don’t overcomplicate things. You know, KISS, right? Keep it simple, stupid. So I think that’s helpful. Sorry if anyone has a kid. I know there are people who listen to this with kids in the car, so sorry if they heard that, but it’s fine. So I actually don’t think in conclusion that I’ve really answered the question what it is, but what I hope I’ve done is express the major concerns and considerations because I actually think that’s more important because the agreement itself, the SAFE itself is important.

Matthew Foreman [00:26:14]:
So that was the 61st episode of How Tax Works. I hope you learned something. We’ll be back in 2. short weeks. In those 2 weeks, I will talk about comments, tax lawyers over here while on vacation. Thank you for listening and, uh, enjoy the music.