Internal Revenue Code Section 1202 has the potential to generate significant US federal income tax savings. However, qualifying a business and a shareholder’s specific shares requires a careful analysis of the law and facts.

Below is a discussion of the general requirements of Section 1202 and examples of how these rules apply to common scenarios. Look for planning techniques, potential pitfalls, and areas of ambiguity.

Background

Section 1202 permits certain shareholders in qualifying corporation to exclude from federal gross income all or a portion of their gain realized upon selling eligible qualified small business stock (QSBS). Stock must be that of a C corporation; stock of an S corporation can’t qualify as QSBS for these purposes. This tax exclusion has been around since 1993 but has seen increased popularity in recent years due to the lower 21% corporate income tax rate and other factors.

What is the Section 1202 Benefit?

Very generally, if stock qualifies as QSBS and is held for at least five years, then noncorporate shareholders such as individuals and trusts may exclude from federal gross income a portion or all of the gain realized upon selling the stock, up to $10 million reduced by eligible gain previously excluded or 10 times the shareholder’s adjusted tax basis in the stock that was sold, whichever is greater.

The amount of eligible gain that may be excluded depends on the date of the stock issuance.

• QSBS issued after September 27, 2010, qualifies for 100% gain exclusion
• For stock issued between February 18, 2009, and September 27, 2010, 75% of eligible gain may be excluded
• For stock issued between August 11, 1993, and February 17, 2009, 50% of eligible gain may be excluded

Why Was Section 1202 Enacted?

According to a House committee report from August 10, 1993, the date of Section 1202’s original enactment, the provision was intended to provide “targeted relief for investors who risk their funds in new ventures, small businesses, and specialized small business investment companies,” to “encourage investments in these enterprises” and to “encourage the flow of capital to small businesses, many of which have difficulty attracting equity financing.”

Section 1202(k) reserves, to the Secretary of the Treasury, the power to enact regulations to carry out the purposes of the rules. However, to date, very limited guidance has been released, leaving much of Section 1202 open to interpretation in accordance with the statutory language, legislative intent, and other guidance.

Does Stock Qualify If It Was Bought from Another Person?

Generally, no.

The benefit only applies to stock that is originally issued to the shareholder by the C corp in exchange for money or other non-stock-property, or as compensation for services provided to such C corp. Therefore, stock is usually not QSBS if it’s received from another person via purchase.

However, certain transfers of QSBS, such as by gift or at death, may qualify. For example, QSBS transferred to a family member or to a trust may retain its QSBS status, and each transferee may have its own Section 1202 exclusion if the transferee is considered a separate taxpayer, based on the facts and circumstances.

Can Stock Repurchased by the Issuing C Corp Disqualify the Stock?

It depends on how close the repurchase was to the stock issuance, the amount repurchased, and the reason for the repurchase.

Stock can lose its QSBS status if the C corp repurchases a certain amount of its stock from any shareholder within a certain amount of time surrounding the issuance in question. For repurchases from any shareholder, the window is the two-year period surrounding the issuance, and for repurchases from the taxpayer or a related person, the window is the four-year period surrounding the issuance.

If the amount repurchased is minimal or if another exception applies, such as a repurchase from a retiring employee or director or a repurchase incident to death, divorce, or disability, then the repurchase may not disqualify the stock issuance.

Can a Partner in a Partnership That Owns the Stock Qualify?

Yes, under certain circumstances.

If a pass-through entity such as a partnership or S corp holds QSBS, then a pass-through interest holder such as a partner or S corp shareholder may qualify for the Section 1202 exclusion. Specifically, the pass-through interest holder may exclude their pro rata share of the pass-through entity’s gain realized up to the greater of $10 million or their pro rata share of 10 times the pass-through entity’s basis in the QSBS stock sold by the pass-through entity.

However, the pass-through interest holder will only qualify to the extent that they held the pass-through interest on the date that the pass-through entity acquired the stock, and at all times thereafter until the stock is sold. Thus, a pass-through interest holder who acquires their interest after the pass-through entity has acquired the stock will generally not qualify, and a pass-through interest holder cannot qualify with respect to subsequent increases in their pass-through interest.

Although these rules may seem to be relatively straightforward, determining whether a partner with a profits interest, a carried interest, or a varied interest in a partnership qualifies is best determined by a professional.

Can Stock in an S Corp Qualify If the S Corp Converts to a C Corp?

Probably not under a straight conversion scenario such as where the S corp election is revoked, because the stock must be originally issued by a C corp in exchange for non-stock consideration.

However, even though a shareholder’s deemed converted shares may not qualify, new shares received from the C corp in exchange for new and eligible consideration may qualify.

Alternative structures may provide a better result. For example, the S corp may contribute its assets to a new C corp in exchange for C corp shares, but the S corp must hold on to the new C corp shares for at least five years and its shareholder(s) must hold on to their S corp shares until the C corp shares are sold to achieve QSBS treatment.

It’s important to make an informed decision regarding a change in entity form or treatment to structure into QSBS eligibility.

How Small Must the C Corp Be to Qualify?

To be a qualified small business, a C corp’s gross assets measured by the amount of cash and aggregate adjusted tax bases of other property can’t exceed $50 million at any time before, on, or immediately after the stock issuance.

This rule—outlined below—is critical and can easily be tripped up without proper tax planning.

First, except for contributed property, the test refers to adjusted tax basis in the assets, not book basis or fair market value, and the reference to gross assets means no netting of liabilities.

Second, the term immediately after is ambiguous and may include a series of transactions—but clearly includes amounts received in the stock issuance. So, if the C corp is under the threshold before a financing round but exceeds the $50 million threshold when including the money raised in the financing round, then shares issued as part of that transaction would not be expected to qualify.

Third, the assets of corporate subsidiaries that are more than 50 percent owned by the issuing C corp are included for purposes of this test, as are the assets of any predecessor entities of the corporation.

Determining whether a C corp is a qualified small business requires a careful analysis of the company’s history, business, financials, and tax profile. In certain instances, a third-party valuation may be required.

Can Shares Received from the Conversion of a Partnership to a C Corp Qualify?

Probably yes, depending on certain factors, such as the fair market value of the partnership’s assets at the time of conversion.

A common form of converting an entity taxed as a partnership to a C corp is through the filing an elective change in entity treatment. In such transaction, the partnership is deemed to contribute all its assets and liabilities to a new C corp in exchange for corporate stock and then immediately liquidate thereafter by distributing the stock to its partners.

Thus, the stock received by the partnership in the first step may qualify as originally issued by the C corp. Then, since a distribution of stock by a partnership to its partners is a qualified transfer, the stock received by the partners in the second step would be expected to remain QSBS.

However, care must be taken at the time of the conversion.

A special rule provides that, for purposes of the gross asset test, the adjusted basis of any property contributed to the C corp is deemed to be equal to its fair market value as of the time of such contribution.

If the value of the partnership’s assets is more than $50 million at the time of the conversion, then the gross assets test would not be met and the stock would not qualify. If, on the other hand, the fair market value of the partnership’s assets is less than $50 million—a robust valuation may be needed—then the stock received in the conversion would be expected to qualify.

Because the maximum amount of gain excludible under Section 1202 is the greater of $10 million or 10 times the adjusted basis in the stock, a partnership conversion could result in a high gain exclusion, depending on the value of the partnership at the time of the conversion, except to the extent of any built-in appreciation at the time of conversion which is ineligible for this gain exclusion.

Because the rules are complex and guidance is scant, it’s important to consult a skilled tax advisor.

What If the C Corp Has Investment Assets?

There’s no blanket prohibition on holding investment assets, but for substantially all the shareholder’s holding period for the stock, at least 80% by value of a C corp’s assets must be used in the active conduct of one or more qualified trades or businesses.

Because a C corp must actively use its assets, stock may not qualify if the C corp has too many investment assets.

For example, the active business requirement isn’t met if the C corp holds non-business real property, and the value of such property is more than 10 percent of the value of all its assets. A C corp may also fail the test if it owns a less than 50 percent interest in another corporation and the value of such interest is more than 10 percent of the value of all its assets.

Preserving Small Business Treatment

Notwithstanding these rules, in accordance with its intent to encourage investment in small businesses, there are several rules in Section 1202 that preserve qualified small business treatment for businesses in early stages.

For example, certain assets used in start-up activities or research and experimentation activities are treated as actively used in the business. In addition, for the first two years of a company’s existence, assets that are held for reasonably required working capital needs or are held for investment and are reasonably expected to be used within two years to finance research and experimentation or increases in working capital needs are treated as used in the active conduct of a qualified trade or business.

After two years, however, no more than 50 percent of the C corp’s assets can be considered actively used in the business by virtue of applying the working capital safe harbor. This is another important requirement, especially if the company does not book intangibles.

What Is a Qualified Trade or Business?

As mentioned previously, the C corp’s assets need to be used in a qualified trade or business. The term qualified trade or business is defined by exclusion. The following businesses do not qualify for Section 1202:

• Any trade or business 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
• Any banking, insurance, financing, leasing, investing, or similar business
• Any farming businesses, including the raising or harvesting of trees
• Any business involving the production or extraction of minerals or other resources for which depletion is allowable under Section 613 or 613A
• Any business of operating a hotel, motel, restaurant, or similar business

Other than this list of nonqualified businesses, there is no reliable guidance in Section 1202 to assist taxpayers in determining whether a C corp’s business is qualified. The IRS has issued informal guidance in the form of private letter rulings, but such guidance can only be relied upon by the taxpayer to whom it’s issued. It isn’t binding on the IRS for other taxpayers’ situations.

Informal Guidance and Insight

Nevertheless, such informal guidance provides insight into how the IRS might interpret a specific business.

Generally, a business isn’t qualified if it offers value to customers primarily in the form of services or individual expertise. On the other hand, a company that uses its assets, tangible or intangible, to provide value for customers may be engaged in a qualified business, even if the business is closely related to an excluded business.

For example, the IRS has privately ruled that a company that developed a tool for sale to health care companies was not engaged in health services because it did not employ health care professionals and it was not involved in the diagnosis or treatment of patients.

In another private letter ruling, the IRS held that a company was not engaged in consulting services since the services were ancillary to its primary business and the company did not separately bill for such consulting services.

A few times, the IRS has referred to the common dictionary definitions of terms to discern whether a company is engaged in a qualified business for Section 1202 purposes.

For example, a company that operated a website that connected lessors with lessees was engaged in brokerage services—an excluded business—because it acted as an intermediary with respect to property. On the other hand, a company that connected insurance companies with insured persons qualified because it provided administrative services beyond that of an intermediary.

As you can see, determining whether a company is engaged in a qualified trade or business heavily depends on the facts and circumstances. In some instances, a private letter ruling request may be recommended.

We’re Here to Help

For assistance with Section 1202, please contact your Moss Adams professional.

Additional Resources

• Private Clients Practice
• Tax Services
• Transactions Services