Tax reform has made qualified small business (QSB) stock under Section 1202 an even more powerful tax planning tool for private companies and their owners.
QSB stock offers a generous tax incentive that was strengthened considerably in 2010. Taxpayers acquiring QSB stock after Sept. 27, 2010, can generally exclude 100% of their gain when selling, and none of this gain is added back for alternative minimum tax purposes. The full gain exclusion can offer extraordinary savings and makes QSBs an attractive structure for owners of entrepreneurial enterprises who plan to eventually sell. Despite this, QSB stock has remained an underused tax incentive, as private companies overwhelmingly organize as pass-throughs.
Tax reform should prompt a re-evaluation of the C corporation and QSB options. The 21% corporate rate is significantly lower than the top individual rate, and that alone is prompting some pass-throughs to consider converting to C corporations. The potential to qualify as a QSB could increase the benefit of a conversion, and may be powerful enough to provide a better result for owners who would not otherwise consider a C corporation conversion just for the lower rates.
The QSB structure does not come without restrictions. To qualify, QSB stock must be original issue stock in a domestic C corporation meeting active business requirements with aggregate assets not exceeding $50 million (immediately after the stock is issued). The exclusion is only available for noncorporate taxpayers who have held the stock for five years, and is limited to the greater of $10 million, or 10 times the adjusted basis. The full requirements are discussed in more detail below, along with examples illustrating the potential benefits.
To illustrate how valuable the incentive can be, consider an owner (“Sally”) who acquired 100 shares of QSB stock in 2011 for $5 million in an original issuance:
In 2019, Sally sells all 100 shares of her QSB stock for $50 million. Absent the QSB provision, Sally would recognize a $45 million capital gain and pay $9 million in federal income tax (assuming a 20% capital gains rate) and $1.7 million in net investment income (NII) tax. On the other hand, if the QSB stock exclusion applies, Sally excludes the entire $45 million gain from income and pays no federal income tax or NII tax. Note that Sally’s entire $45 million gain may be excluded from income for income tax and NII purposes because it is less than Sally’s $50 million limitation on gain eligible for the exclusion (the greater of $10 million per shareholder or Sally’s basis of $5 million, multiplied by 10).
Various corporate-level requirements must be satisfied to qualify for the Section 1202 exclusion. The primary corporate level requirements include:
Issuance date requirement
- Issuance date requirement
- Asset test
- Active business requirement
Only stock in a C corporation issued after Aug. 10, 1993, can qualify as QSB stock. The portion of the gain that can be excluded under Section 1202 varies based on when the stock was acquired is:
- A 50% exclusion when acquired from Aug. 11, 1993, to Feb. 17, 2009 (with 7% AMT addback)
- A 75% exclusion when acquired from Feb. 18, 2009, to Sept. 27, 2010 (with 7% AMT addback)
- A 100% exclusion when acquired from Sept. 28, 2010, to the present (no AMT addback)
If the gain is subject to a 50% or 75% exclusion, the non-excluded gain is taxed at 28%, the capital gains rate in effect in 1993, instead of the current rate. In addition, Section 1202 is unavailable if the C corporation engages in certain redemption transactions around the time of the issuance of the stock.
The asset test must be satisfied when a corporation issues potential QSB stock. The test applies to the corporation before and immediately after each issuance, so if a corporation issues stock on more than one date, the asset test must be satisfied with respect to each separate issuance.
Under the asset test, the aggregate gross assets of the corporation cannot have exceeded $50 million at any time before the issuance of stock to the shareholder seeking to take advantage of the Section 1202 exclusion. In addition, the corporation’s aggregate gross assets, including any amounts received in the issuance, must be no more than $50 million immediately after the issuance. Once the asset test is met for a particular issuance, the corporation need not remain below the $50 million asset threshold to preserve the character of QSB stock that met the test upon issuance. Thus, a shareholder can own QSB stock in a C corporation with $1 billion in assets as long as the shareholder acquired the stock at a time when the asset test was satisfied. Stock issued after the $50 million threshold has been exceeded, however, will not be QSB stock.
“Aggregate gross assets” is defined as cash plus the adjusted tax basis of all other property held by the corporation. For this purpose, property contributed to the corporation in a Section 351 non-recognition transaction is deemed to have a tax basis equal to its fair market value at the time of the contribution for purposes of this test. This means that certain private equity transactions may qualify for the Section 1202 exclusion:
Consider a transaction where a partnership, or “Fund,” contributes $10 million to a newly formed C corporation, or “Newco,” in exchange for originally issued stock of Newco. Newco then borrows $15 million from lender. Next, Newco acquires the target corporation, or “Target,” for $25 million when the tax basis of Target’s assets is $5 million. The plain language of Section 1202 suggests that Fund’s stock in Newco qualifies as originally issued stock even though Target’s outstanding stock was acquired by Newco. Note, however, that the IRS has not issued guidance on whether the gross asset test should be applied to Target using a snapshot approach when Fund contributes cash to Newco or by applying step transaction principles after Target is acquired.
Active business requirement
Unlike the asset test, which applies only up to and immediately after a stock issuance, the active business requirement must be met for substantially all of a shareholder’s holding period after QSB stock has been issued. A corporation meets the active business requirement if it uses at least 80% of its assets, measured by fair market value, in the active conduct of a qualified business for substantially all of the selling shareholder’s holding period. A qualified business is any trade or business other than those on a list of prohibited businesses enumerated by the statute. Those prohibited businesses are:
- Trades or businesses involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees
- Banking, insurance, financing, leasing, investing or similar business
- Farming businesses (including the business of raising or harvesting trees)
- Businesses involving the production or extraction of products of a character with respect to which a deduction is allowable under Section 613 or 613A
- Any business of operating a hotel, motel, restaurant or similar business
Certain rules apply to cash and cash equivalents held to fund working capital or to finance research and experimentation of the business. In addition, a corporation cannot satisfy the active business requirement for any period during which more than 10% of the total value of its assets consists of real property not used in the active conduct of a qualified trade or business.
In addition to the corporate-level requirements, various shareholder-level requirements must be satisfied to qualify for the Section 1202 exclusion. Shareholders must be a qualified shareholder, acquire QSB stock at original issuance, and meet a holding period requirement.
The Section 1202 exclusion only applies to a sale or exchange by a taxpayer other than a corporation. Thus, sales by individuals and flow-through entities, including partnerships and S corporations, are eligible.
There are special rules for taxpayers that own qualified business stock through pass-through entities (e.g., partnerships, S corporations, and regulated investment companies). Each such taxpayer may apply the Section 1202 rules to the taxpayer’s proportionate share of gain from the pass-through entity’s disposition of QSB stock as if the taxpayer owned his or her ratable share of the QSB stock directly. In order to apply for this Section 1202 “look-through” treatment, the stock must qualify as QSB stock in the hands of the pass-through entity and the taxpayer must have held its interest in the pass-through entity on the date on which the pass-through entity acquired the stock and at all times thereafter until the disposition of the stock.
Original issue requirement
QSB stock must be acquired by the taxpayer at its original issue (directly from the issuing corporation, or through an underwriter) in exchange for money or other property (not including stock), or as compensation for services provided to the issuing corporation. The legislative history to Section 1202 provides that stock acquired by the taxpayer through the exercise of options or warrants, or through the conversion of convertible debt, is treated as stock acquired in an original issuance. There are exceptions to the original issuance requirement if stock is transferred as a gift or at death, if the stock is distributed from a partnership to a partner, or if QSB stock is exchanged in a tax free contribution under Section 351 or reorganization under Section 368.
A shareholder of QSB stock must hold such stock for more than five years to qualify for the Section 1202 exclusion. The determination of the holding period of stock acquired through the exercise of options or warrants is treated as beginning at the time of exercise and not at the time the option or warrant was acquired (or potentially at the time of a Section 83(b) election, if applicable).
S corporation conversions and transfers to C corporations
If an S corporation revokes its S election and becomes a C corporation, the C corporation stock will not qualify as QSB stock because QSB stock must be C corporation stock in the hands of the shareholder at the time of original issuance and during substantially all of the shareholder’s holding period. In certain instances, an S corporation that intends to transfer its
business to a C corporation may be able to qualify for the benefits of Section 1202.
If the S corporation transfers its assets to a newly formed corporation (or is deemed to transfer its assets to a newly formed corporation), it appears that Section 1202 may apply to the newly issued C corporation stock. This is illustrated in the example below:
An S corporation, or “Corporation Z,” transfers all of its assets to a C corporation, or “Newco,” in exchange for new originally issued Newco stock in a transfer that qualifies under Section 351. At the time of the transfer, Corporation Z’s assets have a fair market value of $30 million and an adjusted tax basis of $20 million (no liabilities are assumed by Newco). If all other requirements are met, it appears that Section 1202 can apply to the Newco stock. Note, however, that the fair market value of the transferred assets exceeded the basis of the assets by $10 million at the time of the transfer. This built-in gain is not eligible for the Section 1202 exclusion (i.e., only gain from post-transfer appreciation of the Newco stock is eligible for the exclusion). In this example, it is assumed that Corporation Z does not have any subchapter C earnings and profits, and therefore would not be subject to the Section 1375 tax on passive investment income on retained investment assets, if any, or on dividends from Newco.
Partnership conversions to C corporations
Section 1202 specifically provides for converting a partnership into a C corporation in which the converted partnership interests are treated as acquisitions that can qualify for the QSB exclusion. Consider the following example for how a conversion can be a powerful planning tool:
“Partnership X” is a business that would otherwise qualify under Section 1202 if organized as a C corporation. “Individual A” and “Individual B” each own 50% of the outstanding interests in Partnership X. In 2018, Partnership X converts under local law to a corporation named “Corporation X” (see Rev. Rul. 2004-59). Partnership X had assets with a fair market value of $40 million and a tax basis of $40 million (and no liabilities). Individual A and B each had a tax basis in their respective partnership interest of $20 million. Thus, Individual A and B each have basis in their Corporation X stock of $20 million.
In 2024, Individual A and B each sell all their respective outstanding stock in Corporation X for a total of $500 million ($250 million each). Absent the Section 1202 QSB provision, each would recognize a $230 million capital gain and pay $46 million in federal income tax (assuming a 20% capital gains rate) and $8.7 million in NII tax. On the other hand, if the Section 1202 QSB exclusion applies, each of Individual A and B can exclude $200 million of the gain from gross income, recognize the remaining $30 million of gain, and pay $6 million of federal income tax (plus $1.14 million of NII tax).
Note that only a portion of Individual A and B’s respective gain may be excluded from income because the total gain exceeds the limitation. The gain in excess of the limitation must be included in income. In this instance, each individual’s limitation on gain eligible for the Section 1202 exclusion is $200 million (i.e., the greater of $10 million or $200 million (10 multiplied by stock basis of $20 million)).
Thus, Individual A and B have, taken together, permanently excluded $400 million of capital gain from gross income and saved $80 million in federal income taxes. In addition, from 2018 to 2024, all of the operating income of Corporation X has been taxed at the favorable C corporation rate of 21% instead of at individual rates.
Section 1045 rollovers of QSB stock
Even if a sale of QSB stock does not qualify for the Section 1202 exclusion because the taxpayer has not met the five-year holding period requirement or the gain exceeds the limitation threshold ($10 million or 10 times basis), the gain on the sale may still be deferred it the taxpayer reinvests the proceeds in a QSB and elects to defer the gain.
The Section 1045 deferral provision generally provides that if a qualifying taxpayer sells QSB stock that was held for more than six months, elects to apply the Section 1045 deferral provision, and reinvests the sale proceeds in other QSB stock
within 60 days, then the gain on the initial sale is not recognized. The basis of the replacement stock must be adjusted to take into account the unrecognized gain. In addition, the replacement stock must be acquired in a “purchase” where the basis of such stock would be its cost but for the adjustment to basis under Section 1045 to preserve the unrecognized gain from the initial sale.
The benefits of the Section 1202 exclusion can be significant. Taxpayers should carefully examine whether their current investments are eligible for the provision and consider structuring future investments to qualify. Taxpayers that are considering the conversion of a business entity from a flow-through entity to a C corporation should evaluate whether the conversion can be structured in a way that would qualify the new C corporation under Section 1202.
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