Section 1202 is one of the lesser known but highly beneficial provisions of the Internal Revenue Code (the Code) regarding business investment.1 Originally enacted in 1993 and amended several times over the years, Section 1202 currently permits the exclusion of 100% of a shareholder’s recognized gain from the sale of qualified small business (QSB) stock ( QSBS), subject to limitations and if certain conditions are met.
An important requirement is that the issuing company must be a domestic C corporation. After the 2017 tax law, which dramatically reduced the US federal corporate tax rate to 21% (from 35%), using a C corporation for a new business has become much more popular. In sum, the current tax climate can make an investment in a C corporation very tax efficient if the investment is in QSBS.
We discuss some questions to consider regarding qualification.
Original Issue Requirement
For a holder’s shares to qualify as QSBS, the holder generally must acquire the shares directly from the QSB in exchange for cash, goods, or services rendered.2 Although the purchase of shares through an underwriter does not disqualify them,3 they cannot be purchased from another shareholder.
A redemption may disqualify an issue. A redemption is disqualifying if it occurs: (a) within a 4-year period commencing two years before the issue of shares and the shares of certain parties related to the purchasing shareholder are redeemed; or (b) within 2 years commencing one year before the issue of shares and more than 5% of the total value of all outstanding shares are redeemed.4
If a significant shareholder wishes to sell their shares and they know that new investors can apply for QSBS status, the shareholder must sell their shares to a buyer and not to the company. However, this buyer cannot use the QSBS exemption, as it requires an original share issue.
Potential investors who wish to ensure that they will be able to take advantage of the QSBS exclusion when selling their shares should request representations and undertakings from the issuer that it has not made and will not make any redemptions that would disqualify the action of QSBS. treatment in the future.
Limitation of gain per issuer excluded
Section 1202 only allows an exclusion of the gain from the sale of QSBS up to the greater of $10 million or ten times the taxpayer’s adjusted base in the stock.5 For example, if shares were bought for $500,000 and sold for $10 million, the entire gain of $9.5 million would be excluded from taxable income in the year of disposition. If, however, the same stock were sold for $11 million, only $10 million of the total $10.5 million gain would be excluded, and the remaining $500,000 gain would be taxed at capital gain rates. usual.
Definition of qualified small businesses
The Code requires the issuing company to be incorporated domestically, to be actively engaged in a qualified trade or business (see below), and that the company’s total gross assets cannot exceed $50 million. dollars after issuance.6
Skilled trade or business. The Code lists several areas of activity that are excluded from QSBS treatment. They include: (i) trades or businesses involving the provision of services in the following fields: (a) healthcare, (b) law, (c) engineering, (d) architecture, (e) accounting, (f) actuarial services, (g) performing arts, (h) consulting, (i) athletics, (j) financial services, (k) brokerage services, or (l) any trade or business whose main asset is the reputation or competence of one or more of its employees; (ii) banking, insurance, financing, leasing or investment activities; (iii) agricultural businesses, including raising or harvesting trees; (iv) businesses involving the production or extraction of products for which depletion allowances are permitted; and (v) companies operating hotels, motels or restaurants.seven
The disqualification of companies involved in the production or extraction of certain products can be a trap for the reckless energy company, who must ensure that their activities do not disqualify them from QSBS status. This disqualification explicitly applies only to activities eligible for depletion deductions under Sections 613 and 613A of the Code.8 Section 613 lists several types of minerals, pits, and other natural deposits that allow the owner, lessee, or a combination of the two to take deductions based on percentages set by law from the gross income of the property. .9 Section 613A provides special rules for oil and gas production, which are not calculated for deduction according to the percentages provided in Section 613(b).ten
The depletion deduction rules under Sections 613 and 613A are highly technical and complex, and a prudent taxpayer would consult their tax advisors to determine if they are eligible for the depletion, and therefore disqualified from QSBS treatment.
Additionally, the IRS will likely review any claim that a service business is a QSB. Thus, any such company should carefully consider whether it is qualified.
Trade or active business. Once a company determines that its activities are of the correct type to qualify for QSBS treatment, it must also confirm that it is actively engaged in those activities.11 This ensures that a holding company that has many different portfolio investments cannot claim QSBS status. Active participation is defined at least 80% of the value of the company’s assets are used in one or more qualifying trades or businesses. For purposes of the business activity requirement, the law allows the issuing company to look to a subsidiary of the company to meet this business or active business requirement, as long as the parent company owns at least 50% of the subsidiary. .12
Limitation of gross assets. The final requirement is that the company’s total gross assets cannot exceed $50 million after issuance of the planned SQBS.13 This limit includes all amounts received in the actual issue transaction and must also calculate the gross assets of any “predecessor company”, as if the company had been created as a result of a reorganization or other restructuring.14
In general, aggregate gross assets refer to the sum of cash on the company’s balance sheet plus the adjusted tax base of all assets.15 Although the tax base of an established corporation’s assets can be quite low, there is a big exception for assets actually or deemed to be contributed to a corporation on a tax-free basis. In such cases, the company must use the fair market value of these assets at the date of contribution.
In this regard, an LLC incorporation creates a trap for the unwary. An LLC incorporation is treated as a deemed contribution of assets to a newly formed corporation. So when an LLC incorporates, the newly incorporated company must use the fair market value of its assets plus balance sheet cash to determine whether the $50 million threshold has been met.
Burden of proving QSBS status
As in all situations where a statutory exclusion from income is at issue, the burden of proof is on the taxpayer in the event of controversy or assertion by the IRS that certain deductions or exclusions from income were incorrectly taken. Therefore, also in the QSBS context, the onus is on the taxpayer to be able to establish that the stock they hold is QSBS and therefore the income exclusion was appropriate. Typically, a savvy taxpayer will require a business claiming to issue QSBS to give undertakings regarding how the business has conducted business in the past and how it will conduct itself in the future.
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1 All section references are to the Internal Tax Code or Treasury Regulations promulgated thereunder.
2 Section 1202(c)(1)(B)(i)-(ii). An exchange of goods or services raises additional issues to consider.
3 Section 1202(c)(1)(B).
4 Section 1202(c)(3)(A)-(B). The regulations provide for a de minimis exception to the two redemption rules. Section 1.1202-2(a)(2), (b)(2)
5 Section 1202(b)(1)(A)-(B)
6 Section 12020(d)(1)(A)-(C)
seven Section 1202(e)(3)
8 Section 1202(e)(3)(D)
9 Section 613(b)(1)-(7)
ten Section 613A(a)
11 Section 1202(e)(1)
12 Section 1202(e)(5)
13 Section 1202(d)(1)
14 Section 1202(d)(1)(A)-(B)
15 Section 1202(d)(a)(A)