Member Article

Like most industries, tech startups have been deeply impacted by the COVID-19 pandemic. As they scramble to adapt to a rapidly changing climate, tech leaders are asking if, and to what extent, their businesses can benefit from the $2 trillion stimulus package known as the CARES Act. Briefly, the newly-enacted CARES Act provides 883 pages of benefits to help combat the economic damage of the COVID-19 pandemic, including refundable tax credits for individuals and various infusions of capital for businesses wishing to retain employees.

Tech startups have reason to be hopeful that the new law will provide them special benefits. Policymakers have long provided significant tax and business preferences to the industry, notably the qualified small business stock ("QSBS") tax provisions of IRC sections 1202 and 1045. Where a company is considered a qualified small business under IRC section 1202(e)(3), founders, early employees, and other investors can exclude up to $10 million of gain from the sale of their shares, provided they have held the QSBS for five years. In addition, where founders or early employees of a startup have not met the five year holding period, they can still defer (rather than exclude) gain on the sale of the QSBS provided they reinvest in another qualified small business within 60 days.

The CARES Act, however, may not be so generous to tech companies. Specifically, the Paycheck Protection Program ("PPP") that is at the heart of the new law may not be available to tech startups and other qualified small businesses.

Here's why: The PPP provides refundable loans to businesses with less than 500 employees in order to help those companies cover payroll costs, as well as mortgage interest, rent, and utility costs. The issue, as already identified by Speaker of the House Nancy Pelosi, is that Small Business Administration's ("SBA") affiliation rules may treat tech startups as having more than 500 employees. Where startups have received significant funding from one or more investors, the SBA affiliation rules aggregate the employees of all the startups those investors have funded. The result is that the startups may be treated as having more than 500 employees under the SBA affiliation rules – and ineligible for a PPP loan – even though each startup actually has less than 500 employees.

Barring a change to the SBA affiliation rules, tech startups and, in particular, qualified small businesses under IRC section 1202(e)(3), must be careful to ensure that they qualify for PPP loans.

PPP Loans in Brief

As described in prior Hanson Bridgett guidance, section 1102 of the CARES Act created the PPP under the auspices of the SBA. The PPP provides up to $349 billion in forgivable loans to small businesses. The available loan amount is based on a business's average monthly payroll costs for two months plus an additional 25% of that amount (subject to a $10 million cap). Companies can use the loans for a variety of business expenses, including payroll costs, and interest on mortgage obligations, rent, or utilities, provided those costs were set by contract before February 15, 2020.

Potential Curveball: SBA Affiliation Rules

The issue for startup companies is that, for most industries, the SBA’s affiliation standards apply in determining whether the company has more than 500 employees for purposes of PPP loan eligibility. As a general matter, the SBA requires "affiliated companies" to count their total employees in determining whether the 500 employee threshold is met. According to the SBA, "affiliation" is determined based on the power to control a company, whether exercised or not. The SBA generally applies a totality of the circumstances analysis to determine the ability to control, but if a person (including any individual, concern or other entity) owns 50% or more of the company's voting stock, control is deemed to exist. Control may also exist with considerably less than 50% ownership by contractual arrangement or when two or more parties own a large share compared to other parties.

For example, assume that a startup has received funding from a particular angel investor in the Valley. Because the angel investor effectively controls the company (through her preferred shares), the angel investor is also deemed to control the startup for SBA affiliation purposes. But the angel investor has also funded other startups and received preferred shares from each one. Under the SBA affiliation standards, the employees of those various startups are likely considered to be employees of the same company. If the total number of employees of the various startups in which the angel investor holds shares exceeds 500, none of those startups is eligible for a PPP loan. On the other hand, startups which have accepted venture capital fund money may be eligible for an SBA affiliation exclusion.

Now for the Good News: SBA Affiliation Exclusions

The current SBA affiliation rules do contain certain exclusions for typical startup investors. For example, 13 CFR section 121.103(b)(5)(i) provides that companies are not deemed "affiliated" where the following investors own shares:

• Venture capital operating companies, (as defined in the U.S. Department of Labor regulations found at 29 CFR 2510.3-101(d));
• Investment companies registered under the Investment Company Act of 1940, (15 U.S.C. 80a-1, et seq.); and
• Investment companies, as defined under the 1940 Act, which are not registered under the 1940 Act because they are beneficially owned by less than 100 persons, (if the company's sales literature or organizational documents indicate that its principal purpose is investment in securities rather than the operation of commercial enterprises).
  
  

Interestingly, the PPP itself contains SBA affiliation carve-outs for certain industries, including hotel and food services companies as well as franchises listed in the SBA's Franchise Directory. However, at least for founders or investors holding shares of QSBS, such industries are likely outside the scope of qualified trades or business under IRC section 1202(e)(3).

Conclusion

Startups – just like nearly all other businesses – desperately need the loans offered under the PPP. But founders should be careful to work through the affiliation rules to ensure their companies properly qualify and report their affiliation status. We suggest founders consult with their major investors and determine whether the company may be subject to the SBA affiliation rules. In addition, founders should consider whether any of the general affiliation exemptions apply. Hanson Bridgett's Tax Group can address PPP questions as well as tax issues related to QSBS under IRC section 1202.