Qualified small business stock gets more attractive

EXECUTIVE SUMMARY

Under Sec. 1202, gain on the sale of qualified small business (QSB) stock held for five years is partially or entirely excluded from income. Since Sec. 1202 was enacted, the maximum exclusion has ranged from 50% to the current 100% of gain on qualifying stock sales. For stock to be QSB stock, the corporation issuing the stock must be a C corporation when the stock is issued, meet two gross-assets tests, and meet active trade or business requirements for substantially all of the shareholder’s holding period. For the holder of the stock to qualify for the exclusion, the holder must acquire the stock at original issuance and must hold the stock for five years. The date of issuance of stock for these purposes depends on how the holder acquired the stock. For the corporation issuing the stock to meet the active business requirements during substantially all of the shareholder’s holding period, it must be an “eligible corporation,” and it must use at least 80% (by value) of its assets in the active conduct of one or more “qualified trades or businesses.” Assets held for “reasonably required working capital needs” are treated as used in a corporation’s active conduct of a trade or business. The Tax Court has defined working capital needs as the amount of cash reasonably expected as being sufficient to cover a corporation’s operating costs for a single operating cycle. The amount of gain taken into account in a year under Sec. 1202 is limited by a $10 million cumulative limit and an annual limit of 10 times the basis of QSB stock sold during the year that apply per shareholder and per corporation.

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As part of the law known as the Tax Cuts and Jobs Act (TCJA),¹ Congress reduced the corporate tax rate from a high of 35% to a flat 21%. This change has led many to speculate that C corporations, long the entity choice of last resort courtesy of the double taxation that is the hallmark of Subchapter C,² are poised for a resurgence.

Should this come to fruition, taxpayers and their advisers will need to familiarize themselves with a tax incentive that has lain largely dormant since its enactment over two decades ago, but that, courtesy of recent changes, offers an unparalleled benefit to those who choose to do business as a C corporation: Sec. 1202.

Sec. 1202, in general

Sec. 1202(a) provides that a noncorporate shareholder can exclude 50% of the gain from the sale of qualified small business (QSB) stock that has been held for five years.³ QSB stock must be stock in a C corporation; thus, Sec. 1202 is generally not available to exclude gain on the sale of S corporation stock or a partnership interest.

The 50% exclusion percentage was increased to 75% for stock acquired from Feb. 18, 2009, to Sept. 27, 2010,⁴ and then again to 100% for stock acquired on or after Sept. 28, 2010. The 100% exclusion, unlike many other tax breaks, is permanent.⁵

This ability to exclude 100% of the gain on the sale of stock — stock sold for cash, moreover — is virtually unmatched throughout the Code. Yet, despite this fact, poll a room full of tax advisers, and, outside of Silicon Valley, surprisingly few are familiar with Sec. 1202.

How is this possible? A quick review of the history of Sec. 1202 reveals the answer, while also shedding light on why so many unanswered questions remain surrounding the application of this tremendously advantageous provision.

History of Sec. 1202

Sec. 1202 was added to the Code as part of the Revenue Reconciliation Act of 1993,⁶ with the stated purpose of providing targeted relief for investors who risk their funds in new ventures and small businesses. At the time, long-term capital gain was taxed at the same rates that apply to ordinary income, subject to a maximum rate of 28%.

Under the original version of the provision, gain from the sale of QSB stock acquired on or after Aug. 10, 1993, was eligible for a 50% exclusion, resulting in an effective rate on 100% of the gain of 14%. Because of the required five-year holding period, however, the earliest date a shareholder was able to apply the 50% exclusion was Aug. 10, 1998.

By 1997, however, Congress had reduced the long-term capital gain rate from a high of 28% to 20%. As part of the same legislation, Sec. 1(h) was modified to provide that any gain excluded under Sec. 1202 was taxed at 28%.⁷ This latter change yielded an effective tax rate on a shareholder’s full gain on the disposition of QSB stock — including the 50% portion excludable under Sec. 1202 — of 14%.⁸ When compared to a regular tax rate of 20% on long-term capital gain, the benefits of Sec. 1202 were largely deemed by the tax community to be not worth the effort.

While Sec. 1202 may have been rendered insignificant in 1998, it was virtually eliminated in 2003, when Congress further reduced the top rate on long-term capital gains to 15%.⁹ Tax advisers saw little reason to pursue a provision that came with a host of requirements yet yielded a tax rate benefit of less than 1%.

Sensing that the provision had failed to achieve its original objective, in 2009 Congress increased the exclusion percentage to 75%, and again in 2010 to 100%.¹⁰ The move to a 100% exclusion was temporary for several years and routinely extended retroactively after its expiration as part of an extenders package, further muting its impact. It was not until the passage of the Protecting Americans From Tax Hikes Act in late 2015 that the 100% exclusion was made permanent. As a result, the majority of tax advisers have only recently begun dipping their toes into the Sec. 1202 pool.

In addition to failing to provide the intended incentive of spurring investment, the fact that Sec. 1202 went virtually unused for its first two decades resulted in a dearth of relevant authority, whether in the form of administrative rulings or judicial precedent. As a result, there are countless unanswered questions surrounding the provision, from the application of the active business requirement to the definition of “substantially all” to the treatment of corporate liquidations. Thus, while the potential for a 100% exclusion will likely lead to an explosion in the number of taxpayers using Sec. 1202, as this article will explain, those tax advisers must proceed with caution until further guidance addresses these unresolved issues.

Meeting the QSB stock requirements

Only gain from the sale of QSB stock is eligible for exclusion under Sec. 1202. To meet the definition of QSB stock, certain requirements must be met at the time of the stock’s issuance, while others must be met during substantially all of the shareholder’s holding period of the stock.

Requirements that must be met on the date of issuance

C corporation requirement

On the date of issuance, the issuing corporation must be a domestic C corporation, and the stock must be issued after Aug. 9, 1993.¹¹

Qualified small business requirement

In addition, on the date a corporation issues its stock, the corporation must meet two tests for its gross assets (the gross-assets test):¹²

1. At all times from Aug. 9, 1993, through the date of issuance, the aggregate gross assets of the corporation (or any predecessor) must not have exceeded $50 million.¹³ Thus, if at any point after Aug. 9, 1993, the gross assets of a corporation exceed $50 million, the corporation can never again issue stock that will be QSB stock, even if, on the date of a subsequent issuance, the gross assets are again below $50 million.
2. Immediately after the date of issuance (and after taking into account amounts the corporation received in the issuance) the aggregate gross assets of the corporation must not exceed $50 million.¹⁴

The corporation must agree to submit reports as required by regulation, but, to date, no requirements have been issued.¹⁵

Example 1: X Co., a domestic C corporation, issues stock to A in 2006 when its gross assets are $20 million. In 2012, and 2014, X Co. issues stock to B and C, respectively, when its aggregate gross assets are $30 million and $45 million. In 2018, X Co. issues stock to D, and immediately after the issuance, X Co.’s aggregate gross assets are $52 million. This is the first time X Co.’s aggregate gross assets have exceeded $50 million.

The fact that X Co.’s gross assets exceed $50 million in 2018 does not taint the stock X Co. previously issued to A, B, and C. It does, however, mean that the stock issued to D cannot qualify as QSB stock, and that no future issuance of X Co. stock will qualify as QSB stock, even if X Co.’s gross assets again drop below the $50 million threshold.

Aggregate gross assets means the amount of cash the corporation holds plus the aggregate adjusted basis of other property the corporation holds.¹⁶ Because this test looks to the basis of the corporation’s assets, rather than the value of those assets, a corporation could have substantial self-created intangible value (such as goodwill) without running afoul of the $50 million limit.

For purposes of Sec. 1202, the adjusted basis of any property contributed to the corporation is equal to its fair market value (FMV) on the date of contribution.¹⁷ This prevents shareholders from circumventing the $50 million threshold by contributing low-basis/high-value property to a corporation in exchange for QSB stock.¹⁸

In testing the $50 million limit, all corporations that are members of the same parent-subsidiary controlled group are treated as one corporation.¹⁹

Original issuance requirement

QSB stock must be acquired by the current holder at “original issuance.” This generally means that the stock must be acquired directly from the issuing corporation in exchange for money or other property (not including stock) or as compensation for services provided to the corporation (other than services performed as an underwriter).²⁰ Thus, a shareholder who acquires stock from an existing shareholder in a cross-purchase will not be treated as having received the stock at original issuance.

The committee reports to the Revenue Reconciliation Act of 1993 clarify that stock a shareholder acquired through the exercise of options or warrants or through the conversion of convertible debt is treated as acquired at original issuance.²¹

In certain situations, stock can be treated as having been received at original issuance even when the shareholder is not the original owner of the shares. When stock is received via a gift, at death, or as a distribution from a partnership, the stock is treated as having been received by the transferee in the same manner as the transferor.²² Thus, if the stock was acquired by the transferor at original issuance, the transferee will be treated as having done the same. For stock distributed from a partnership to a partner to meet the definition of QSB stock in the hands of the partner, however, (1) the stock must have been QSB stock in the partnership’s hands (ignoring the five-year holding period requirement); (2) the partner must have been a partner from the date the partnership acquired the stock through the date of the distribution; and (3) the partner cannot treat stock the partnership distributed as QSB stock to the extent the partner’s share of the distributed stock exceeds the partner’s interest in the partnership at the time the partnership acquired the stock.²³

Example 2: On June 1, 2014, A contributes $1,000 to X Co. in exchange for stock. The stock meets all the requirements of QSB stock. On July 15, 2018, A gifts the shares to B. B is treated as having acquired the stock in the same manner as A — in exchange for a transfer of cash to X Co. — and thus is treated as having acquired the stock at original issuance.

Determining the issuance date

Determining the issuance date of QSB stock is critical for three reasons. The issuance date:

1. Starts the clock for purposes of the five-year holding period requirement;
2. Determines whether gain from the sale of the QSB stock is eligible for a 50%, 75%, or 100% exclusion; and
3. Marks the date on which the gross-asset test is measured for the shareholder receiving the stock.

When a shareholder contributes cash or property to a corporation in exchange for stock, the issuance date is the date of the contribution.²⁴ When a shareholder receives stock in connection with the performance of services, the committee reports clarified that the issuance date is determined in accordance with the rules of Sec. 83.²⁵

Example 3: In 2013, A receives 1,000 shares of X Co. stock in exchange for services provided. The stock is restricted and nontransferable until 2018. A does not make a Sec. 83(b) election. In 2018, A fully vests in the stock, and at that time, in accordance with Sec. 83, A includes the FMV of the stock in income. For purposes of Sec. 1202, the stock’s issuance date is 2018, when the stock vests, rather than 2013, when it was issued.

When stock is received by a shareholder upon the exercise of an option, warrant, or convertible debt, the issuance date is the date of exercise or conversion.²⁶ An unexercised option or warrant is never considered QSB stock, even if the underlying stock would meet the definition of QSB stock in the hands of the option holder.²⁷

When convertible QSB stock is converted into other stock of the same corporation, the stock received in the conversion is treated as QSB stock, and the date of issuance is the date the convertible stock was originally acquired by the shareholder.²⁸

Example 4: A is issued 1,000 shares of convertible preferred stock in X Co. in 2012. The convertible preferred stock meets the definition of QSB stock. In 2015, A converts the stock into 2,000 shares of X Co. common stock. The common stock received by A is treated as QSB stock, and A is treated as having originally acquired the common stock in 2012.

When stock is received via gift, inheritance, or as a distribution from a partnership, the acquisition date is the date on which the transferor acquired the stock.²⁹

Example 5: On June 1, 2014, A contributes $1,000 to X Co. in exchange for stock. The stock meets all the requirements of QSB stock. On July 15, 2018, A gifts the shares to B. In July 2019, B sells the stock. Because B is treated as having acquired the stock on June 1, 2014, the five-year holding period is met.

Special basis rules

To prevent abuse of Sec. 1202 whereby shareholders attempt to exclude gain attributable to preinvestment appreciation, special rules are prescribed for determining a shareholder’s initial basis in QSB stock.

If a shareholder transfers property (other than cash or stock) to a corporation in exchange for stock, for the purposes of Sec. 1202, the shareholder’s basis in the stock is treated as not less than the FMV of the property exchanged. This is contrary to the general rule of Sec. 358, which gives a shareholder in a Sec. 351 transfer a basis in the stock received equal to the adjusted basis of any property transferred to the corporation.³⁰ The effect of this rule, however, is to ensure that only appreciation that occurs after acquisition of the stock is eligible to be excluded under Sec. 1202.

Example 6: In 2012, A transfers property with a basis of $10,000 and an FMV of $100,000 to X Co. in exchange for stock with an FMV of $100,000. A originally acquired the property in 2008. The X Co. stock meets the definition of QSB stock. In 2018, A sells the X Co. stock for $150,000. For regular tax purposes, A’s holding period in the stock begins in 2008, his basis in the X Co. stock is $10,000, and his gain is $140,000. For Sec. 1202 purposes, however, A is treated as having acquired the stock in 2012 — allowing A to claim the full 100% exclusion — and his basis in the stock is $100,000. Thus, the amount of gain to be taken into account under Sec. 1202 is limited to $50,000, the amount of appreciation that occurred after A acquired the stock from X Co.

Under a similar rule, if a shareholder who holds QSB stock subsequently contributes additional property to the corporation as a contribution to capital, the increase to basis is not less than the FMV of the contributed property.³¹

Requirements that must be met for substantially all of the shareholder’s holding period

To meet the definition of QSB stock, two requirements must be met for “substantially all” of the shareholder’s holding period; specifically, the corporation must be a C corporation and satisfy the “active business” requirement. It is important to understand that these tests do not apply to the entire lifespan of the corporation but rather to the period of time that a shareholder attempting to qualify for the benefits of Sec. 1202 holds the corporation’s stock. Thus, while these tests are measured at the corporate level, the period of time for which they are measured is determined at the shareholder level.

What is ‘substantially all’?

Unfortunately, neither Sec. 1202 nor the underlying regulations define the term “substantially all.” Making matters worse, because Sec. 1202 has so rarely been the subject of administrative rulings or judicial review, the IRS and courts have offered no illumination, forcing tax advisers to look elsewhere for guidance.

In the tax-free reorganization context, the acquiring corporation in a Sec. 368(a)(1)(C) acquisition must acquire substantially all of the assets of the target corporation. In the case of a taxpayer seeking a favorable advance ruling from the IRS, the Service treats the substantially all requirement as having been satisfied if 70% of the gross assets, or 90% of the net assets, of the target corporation are acquired.³² When this standard was tested in court, an acquiring corporation was held to meet the substantially all requirement when 86% of the net assets of a target corporation were acquired,³³ but in another decision, the substantially all requirement was not met when only 68% of the net assets of a target corporation were acquired.³⁴ Thus, in the absence of relevant authority, it is reasonable to presume that achieving 86% or greater of the various tests discussed below should satisfy the substantially all requirement, whether measured in terms of duration or value.

C corporation requirement

For stock to meet the definition of QSB stock, the corporation must be a C corporation on the date of issuance and during substantially all of the shareholder’s holding period.³⁵

Active business requirement

For stock in a corporation to meet the definition of QSB stock, during substantially all of the shareholder’s holding period, the corporation must be an “eligible corporation,” and at least 80% (by value) of the assets of the corporation must be used by the corporation in the active conduct of one or more “qualified trades or businesses.”³⁶

Eligible corporation: The corporation must be an eligible corporation for substantially all of the shareholder’s holding period.³⁷ An eligible corporation means any domestic corporation other than a DISC or former DISC, a regulated investment company, real estate investment trust, REMIC, or a cooperative.³⁸

Qualified trades or businesses: For substantially all of the shareholder’s holding period, at least 80% of the assets of the corporation must be used in the active conduct of one or more “qualified trades or businesses.” A qualified business means any trade or business other than:³⁹

• 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 business (including the business of raising or harvesting trees);
• Any business involving the production or extraction of products of a character for which a deduction is allowable under Sec. 613 (percentage depletion of mines, wells, and other natural deposits) or 613A (percentage depletion of oil and gas wells); and
• Any business of operating a hotel, motel, restaurant, or similar business.

With Sec. 1202 having gone largely unused since its enactment, little interpretation exists defining disqualified businesses beyond the statutory language. This lack of precedent will undoubtedly lead to many disputes between the IRS and taxpayers until a “qualified business” is further defined.

In IRS Letter Ruling 201436001, the IRS addressed the disqualified field of “health.” In the ruling, the taxpayer provided products and services primarily in connection with the pharmaceutical industry, working with clients to help commercialize experimental drugs. Its business activities included research on drug formulation effectiveness; precommercial testing procedures such as clinical testing; and manufacturing drugs. In addition, the taxpayer worked with clients to solve problems in the pharmaceutical industry, such as developing successful drug manufacturing processes. To perform these tasks, the taxpayer used its physical assets, such as its manufacturing and clinical facilities, as well as its intellectual property assets, including its patent portfolio.

The IRS concluded that although the taxpayer worked primarily in the pharmaceutical industry, which is certainly a component of the health industry, the taxpayer did not perform services in the health industry within the meaning of Sec. 1202(e)(3). Rather, the taxpayer’s activities involved the deployment of specific manufacturing assets and intellectual property assets to create value for customers, making it analogous to a parts manufacturer in the automobile industry.⁴⁰

In Owen,⁴¹the Tax Court interpreted the catch-all that removes from the definition of a qualified business “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.” The IRS argued in that case that “one of the principal assets” of a company that sold insurance and financial products — and used 150 employees and 350 independent sales agents to do so — was its owner’s skill. The Tax Court disagreed, concluding that the business’s principal assets were its “training and organizational structure” that allowed it to assemble a team of employees and independent contractors — including the business owner — who sold the company’s policies.⁴²

80% of gross assets test: Once it has been determined that the corporation has been an eligible corporation engaged in a qualified trade or business during substantially all of the shareholder’s holding period of the corporation’s stock, it must be established that during that period, more than 80% of the corporation’s gross assets were used in the active conduct of that trade or business. The statute provides that the value of the corporation’s assets is measured for these purposes; thus, as compared to the $50 million gross-assets test — which looks to the adjusted basis of the corporation’s assets — it stands to reason that the value of all assets, including self-created intangibles such as goodwill — should be taken into consideration in applying the 80% test.⁴³

For purposes of the 80% test, a corporation may be treated as being engaged in an active trade or business even before the corporation has begun generating income.⁴⁴ Assets will be treated as used in an active trade or business if, in connection with any future qualified trade or business, a corporation is engaged in startup activities described in Sec. 195(c)(1)(A),⁴⁵ activities resulting in the payment or incurring of expenditures that can be treated as research and experimental expenditures under Sec. 174, or activities that qualify as in-house research expenses described in Sec. 41(b)(4).

If the corporation being tested owns at least 50%⁴⁶ of the stock in a subsidiary corporation, the corporation is deemed to own its ratable share of the subsidiary’s assets and liabilities.⁴⁷ The corporation will fail the 80% test, however, if more than 10% of the value of its net assets consists of stock or securities in corporations that are not at least 50% owned by the parent corporation.⁴⁸

A corporation will also fail the 80% test if more than 10% of the total value of its assets consists of real property that is not used in the active conduct of a qualified trade or business. For these purposes, the ownership of, dealing in, or renting of real property is not treated as the active conduct of a trade or business.⁴⁹

Treatment of working capital

Sec. 1202(e)(6) provides that any assets that are held as part of the “reasonably required working capital needs” of a qualified trade or business of the corporation, or held for investment and are reasonably expected to be used within two years to finance research and experimentation in a qualified trade or business or increases in the working capital needs of a qualified trade or business, are treated as used in the active conduct of a trade or business.

Neither the statute nor the regulations define a corporation’s “reasonably required working capital needs.” If the IRS deems a cash infusion into a corporation as being in excess of the corporation’s current working capital needs, the excess amount would be treated as not being used in the active conduct of a trade or business, making it more difficult for the corporation to satisfy the 80% test.

In Senate testimony discussing Sec. 1202, Sens. Dale Bumpers, D-Ark., and Joseph Lieberman, D-Conn., urged Treasury to promulgate regulations that would define “reasonably required working capital needs” in a manner similar to those the courts used in applying the accumulated earnings tax of Secs. 531 and 532.⁵⁰

In the seminal case on the issue — Bardahl Manufacturing Corporation⁵¹ — the Tax Court defined a corporation’s working capital needs as the amount of cash reasonably expected as being sufficient to cover the corporation’s operating costs for a single operating cycle. This amount was quantified by multiplying the percentage of the year representing one operating cycle by the annual cost of operations. An operating cycle was further made up of two operating cycles — the time it took from the purchase of raw materials to the sale of final inventory — and the time it took from billing customers to collecting those receivables.⁵²

In the absence of specific guidance under Sec. 1202 as to what constitutes the reasonable required working capital needs of a corporation, it is realistic to assume that working capital on hand that is not in excess of the cost of its next operating cycle may be treated as being used in the active conduct of a trade or business, and would thus count toward the 80% test.

While this interpretation will allow a corporation to maximize the amount of working capital it can count toward satisfying the 80% test during its initial years, the respite is a brief one. Sec. 1202(e)(6) provides that, after a corporation has been in existence for at least two years, in no event may more than 50% of the corporation’s assets be treated as used in the active conduct of a qualified trade or business via the working capital exception.

This creates a paradox of sorts: The stated purpose of Sec. 1202 was to “encourage the flow of capital to small businesses, many of which have difficulty attracting equity financing.” But if a corporation is too successful in raising funds — particularly after it has been in existence for two years — it may find itself with a substantial amount of cash on hand, with the amount that may be counted toward the 80% test limited to 50% of the total assets.

Example 7: X Co. is formed in 2015 and immediately begins operating a qualified trade or business. In 2018, at a time when X Co. has assets being used in the active conduct of its trade or business of $1 million and no other assets, tangible or intangible, X Co. raises $9 million through two rounds of financing. X Co. holds $8 million of the $9 million in working capital at year end, with the other $1 million having been used to purchase equipment and machinery. Because X Co. is more than two years old, only 50% of the $10 million of total assets ($5 million) can be treated as being used in the active conduct of a trade or business by virtue of the working capital exception. In applying the 80% test at the end of 2018, X Co. has assets used in the active conduct of a trade or business of $7 million ($5 million of working capital and $2 million of other assets) and total assets of $10 million. As a result, X Co. fails the 80% test.⁵³

This result makes little sense given the purpose of Sec. 1202. In the preceding example, X Co. has done precisely what Sec. 1202 was designed to accomplish and raised equity financing but, in doing so, may have jeopardized the QSB status of the very shareholders who made the investment. The IRS should address this inconsistency in future regulations.

Applicable exclusion percentage and limitations on excludable gain

Sec. 1202(a) provides that gross income does not include a percentage of any gain from the sale or exchange of QSB stock. The amount of gain eligible for exclusion depends on the applicable exclusion percentage and is subject to cumulative and annual limitations.

Applicable exclusion percentage

QSB stock acquired after Aug. 9, 1993, and before Feb. 18, 2009, is eligible for a 50% exclusion. The exclusion is increased to 75% for QSB stock acquired from Feb. 18, 2009, through Sept. 27, 2010, and to 100% for QSB stock issued on or after Sept. 28, 2010.⁵⁴ For purposes of determining whether stock was acquired on or after Sept. 28, 2010 — and is thus eligible for the 100% exclusion — the acquisition date is determined after the application of Sec. 1223, which generally allows for a tacked holding period in certain tax-free exchanges.⁵⁵

Example 8: A acquires stock in X Co. in 2007. In 2011, A gifts the stock to B. B later sells the stock in 2018. For Sec. 1202 purposes, the stock is treated as acquired by B in 2007, rather than in 2011, because Sec. 1223 allows B to include the time that A held the stock in B’s holding period. As a result, B is only eligible for the 50% exclusion.

Alternative minimum tax preference

For QSB stock acquired before Sept. 28, 2010, Sec. 57(a)(7) includes in the computation of alternative minimum taxable (AMT) income 7% of any gain excluded under Sec. 1202. Gain from the sale of QSB stock acquired on or after Sept. 27, 2010, however, is not subject to the AMT adjustment.⁵⁶

Per-issuer limitations on excludable amounts

The amount of gain that may be taken into consideration under Sec. 1202 is limited before applying the applicable exclusion percentage. It is important to understand the difference: The limitations below apply not to the amount of excludable gain but rather to the total gain that may be taken into consideration under Sec. 1202 before determining the excludable amount. For QSB stock issued on or after Sept. 28, 2010, however, because 100% of the gain is excludable, the total gain and the excludable gain will be one and the same.

There are two limitations: a cumulative limitation and an annual limitation, both of which apply on a corporation-by-corporation and a shareholder-by-shareholder basis. Each year that a shareholder sells QSB stock, the total gain that may be taken into account under Sec. 1202 for each issuing corporation is limited to the greater of:

• $10 million reduced by the aggregate amount of eligible gain taken into account under Sec. 1202 for prior tax years attributable to stock in the corporation (the “cumulative limitation”),⁵⁷ or
• Ten times the aggregate adjusted basis of QSB stock the corporation issued that the taxpayer sold during the tax year (the annual limitation).⁵⁸

  Example 9: A contributes $100,000 to X Co. in 2007 in exchange for 1,000 shares of stock. The stock meets the definition of QSB stock in A’s hands. In 2018, A sells 500 shares of the X Co. stock for $7 million. The total gain on the sale is $6,950,000 ($7 million less $50,000 of allocable basis in 500 shares). A may take into account under Sec. 1202 the greater of:

  • The cumulative limitation of $10 million, or
  • The annual limitation of $500,000 (10 times the basis of the stock sold during the year of $50,000).

Thus, A may take the entire $6,950,000 of gain into account under Sec. 1202. Because the X Co. stock A sold in 2018 was acquired in 2007, the applicable exclusion percentage is 50%; thus, A may exclude $3,475,000 of gain.

In 2019, A sells the remaining 500 shares of X Co. stock for $7,500,000. The total gain on the sale is $7,450,000. A may take into account under Sec. 1202 the greater of:

• The cumulative limitation of $3,050,000 ($10 million reduced by the $6,950,000 taken into account under Sec. 1202 in 2018), or
• The annual limitation of $500,000 (10 times the basis of the stock sold during the year of $50,000).

Thus, A may take into account $3,050,000 of gain into account before applying the applicable exclusion percentage of 50%, resulting in a Sec. 1202 exclusion of $1,525,000.

It is a common misconception that the maximum aggregate exclusion available under Sec. 1202 is $10 million. To the contrary, the application of the annual limitation will allow a shareholder to exclude more than $10 million of total gain.

Example 10: A contributes $1 million to X Co. in 2012 in exchange for 1,000 shares of X Co. stock. The stock meets the definition of QSB stock. In 2018, A sells 500 shares of the X Co. stock for $12 million. The total gain on the sale is $11,500,000 ($12 million less $500,000 of allocable basis in 500 shares). In 2018, A may take into account under Sec. 1202 the greater of:

• The cumulative limitation of $10 million, or
• The annual limitation of $5 million (10 times the basis of the stock sold during the year of $500,000).

Thus, A may take $10 million of the gain into account under Sec. 1202. Because the X Co. stock A sold in 2018 was acquired in 2012, the applicable exclusion percentage is 100%; thus, A may exclude $10 million of gain.

In 2019, A sells the remaining 500 shares of X Co. stock for $13 million. The total gain on the sale is $12,500,000. A may take into account under Sec. 1202 the greater of:

• The cumulative limitation of $0 ($10 million reduced by the $10 million taken into account under Sec. 1202 in 2018), or
• The annual limitation of $5 million (10 times the basis of the stock sold during the year of $500,000).

Thus, even though A excluded $10 million of gain in 2018, A may take into account an additional $5 million of gain in 2019 under the annual limitation. A applies the applicable exclusion percentage of 100%, resulting in a Sec. 1202 exclusion of $5 million.

It is important to note that the language of Sec. 1202(b) allows a shareholder to aggregate all basis and gain related to the sale of stock in the same corporation during a given tax year for purposes of applying the cumulative and annual limitation. This requires careful planning upon the disposition of QSB stock, because if done in the incorrect order, a shareholder may recognize more gain than necessary.

Example 11: In 2011, A acquired 5,000 shares of QSB stock in X Co. with a basis of $1 million (the low-basis shares). In 2013, A acquired another 5,000 shares of QSB stock in X Co. with a basis of $5 million (the high-basis shares). In 2019, the shares are worth $25 million. If A sells only the high-basis shares in 2019, he recognizes gain of $7,500,000 ($12,500,000 value less $5 million basis). A may take into account under Sec. 1202 the greater of:

• $10 million (the cumulative limit), or
• $50 million (10 times the basis of $5 million).

Thus, A may take into account the entire $7,500,000 gain and exclude that amount from income under Sec. 1202.

If A then sells the low-basis shares in 2020, he recognizes gain of $11,500,000 ($12,500,000 value less $1 million basis). A may take into account under Sec. 1202 the greater of:

• $2,500,000 (the cumulative limit of $10 million less the amount taken into account under Sec. 1202 in 2019), or
• $10 million (10 times the basis of $1 million)

As a result, A may take into account under Sec. 1202 and exclude from income only $10 million of the $11,500,000 gain. A must recognize the remaining $1,500,000 of gain.⁵⁹

Example 12: The factsare the same as in the preceding example, except A sells both blocks of shares in 2019. Sec. 1202(b) allows A to combine the basis and amount realized from both blocks of shares in computing the cumulative and annual limitations. The total basis of the sold shares is $6 million, and the total gain is $19 million. A may take into account under Sec. 1202 the greater of:

• $10 million (the cumulative limit), or
• $60 million (10 times the aggregate basis of $6 million).

As a result, A may take into account under Sec. 1202 and exclude from income the entire $19 million gain. By selling all of the shares in one year and aggregating the basis of the 10,000 shares, A is able to exclude from income an additional $1,500,000 of gain when compared with the previous example.

Treatment of gain resulting from the sale of QSB stock that is not excludable under Sec. 1202

Any gain from the sale of QSB stock that is not excludable under Sec. 1202 because the stock was acquired during a period where the applicable exclusion percentage was only 50% or 75% is subject to tax at a rate of 28%.⁶⁰ Gain recognized upon the sale of QSB stock because of the application of the cumulative or annual limit is not subject to the 28% rate, however.

Special circumstances

Corporate liquidations and redemptions

Sec. 1202 allows for an exclusion upon the “sale or exchange” of QSB stock. Thus, if a C corporation sells its assets rather than its stock, Sec. 1202 will not be available to exclude any corporate-level gain resulting from the sale. If the corporation subsequently liquidates by distributing the sales proceeds to its shareholders, however, the shareholders should be able to use Sec. 1202 to exclude any gain upon liquidation. While the statute is silent on the issue, Sec. 331 treats amounts a shareholder received in a complete corporate liquidation as being made in exchange for the stock, and thus any gain recognized by a shareholder holding QSB stock should be taken into account under Sec. 1202.⁶¹ Similarly, Sec. 1202 should be available to exclude any gain a shareholder recognized upon a redemption of shares that is treated as a sale or exchange under Sec. 302(b).⁶²

Example 13 :A is the sole shareholder of X Co. A’s basis in the X Co. stock is $100,000. The stock is QSB stock that was acquired after Sept. 27, 2010, and has been held longer than five years. In 2018, X Co. sells its assets for $5 million at a time when the basis of its assets is $1 million, resulting in corporate-level gain of $4 million. X Co. cannot use Sec. 1202 to exclude any of the $4 million gain. Assume that after federal and state tax, X Co. is left with $3 million of cash, which it distributes to A in complete liquidation. A recognizes $2,900,000 of gain on the liquidation but may use Sec. 1202 to exclude 100% of the gain, eliminating the second level of tax that normally applies to a corporate asset sale followed by a liquidation.

Redemptions

The primary motivation for Sec. 1202 is to encourage capital investment in small businesses; this is the very reason for the requirement that QSB stock be acquired by the shareholder at original issuance. In the absence of a safeguard, corporations could evade the requirement that QSB stock be newly issued stock by redeeming non-QSB stock from a shareholder only to reissue it as QSB stock. To prevent this result, the statute provides two restrictions governing redemptions.

First, any stock a shareholder acquires will not be treated as QSB stock if, at any time during the four-year period beginning on the date two years before the issuance of the stock, the corporation purchased (directly or indirectly) more than a de minimis amount of its stock from the taxpayer or from a person related to the taxpayer. A redemption exceeds a de minimis amount if the aggregate amount paid for the stock exceeds $10,000 and the corporation purchases more than 2% of the stock held by the taxpayer and persons related to the taxpayer.⁶³ The percentage of stock acquired in any single purchase is determined by dividing the stock’s value (as of the time of purchase) by the value (as of the time of purchase) of all stock held (directly or indirectly) by the taxpayer and related persons immediately before the purchase. The percentage of stock acquired in multiple purchases is the sum of the percentages determined for each separate purchase.⁶⁴

Example 14: A holds stock in X Co. In 2018, when A’s X Co. stock is worth $1 million, X Co. purchases $10,000 of A’s X Co. stock. This redemption represents 1% of the total value of X Co. stock A held. In 2019, A contributes $1 million to X Co. in exchange for additional stock. In 2020, when A’s X Co. stock is worth $2 million, X Co. purchases $50,000 of A’s X Co. stock. This redemption represents 2.5% of the total value of the X Co. stock A held and brings the aggregate redemption amount to 3.5%. Because the aggregate amount paid to A within a four-year period beginning two years before the 2019 issuance of X Co. stock to A exceeds both: (1) $10,000 and (2) more than 2% of the X Co. stock A held, the redemptions are not de minimis. As a result, the stock issued to A in 2019 is not QSB stock.

In addition, stock issued by a corporation will not be treated as QSB stock if, during the two-year period beginning on the date one year before the issuance of the stock, the corporation redeemed more than a de minimis amount of stock with an aggregate value (at the time of the respective purchases) exceeding 5% of the aggregate value of all of its stock as of the beginning of the two-year period.⁶⁵ For these purposes, a redemption exceeds the de minimis threshold if the aggregate amount paid for the stock exceeds $10,000 and more than 2% of all outstanding stock. For each redemption, the percentage of the outstanding stock purchased is determined by dividing the value of the purchased stock at the time of the redemptionby the value of all outstanding stock at the time of the redemption.

It should be noted that while the first redemption rule will taint only the stock received by the shareholder who had his or her stock redeemed within the prohibited window, this second redemption rule will taint all stock issued within the two-year window.

Example 15: On Jan. 1, 2017, X Co. has outstanding stock valued at $10 million. On Jan. 1, 2018, A contributes cash to X Co. in exchange for stock. On June 30, 2018, when the value of the outstanding stock of X Co. is $20 million, X Co. redeems some of its stock for $700,000. The redemption represents 3.5% of the stock at the time of redemption. Because the redemption exceeds $10,000 and represents more than 2% of the outstanding stock at the time of the redemption, the redemption is not de minimis. In addition, because the redemption represents more than 5% ($700,000 ÷ $10 million = 7%) of the value of the stock on Jan. 1, 2017 (one year before the Jan. 1, 2018, issuance of stock to A), the stock issued to A is not QSB stock.

QSB stock held in passthrough entity

When QSB stock is held by a partnership or S corporation,⁶⁶ partners or shareholders may exclude their share of any gain the passthrough entity recognized on the disposition of the QSB stock, subject to certain requirements and limitations.⁶⁷

First, the stock sold by the passthrough entity must satisfy all of the requirements necessary to qualify as QSB stock, including the five-year holding period.⁶⁸

Next, a partner or shareholder may only exclude gain under Sec. 1202 if the partner or shareholder held an interest in the partnership or S corporation on the date the passthrough entity acquired the stock and at all times before the sale of the stock by the passthrough entity.⁶⁹

Finally, the partner or shareholder may take into account under Sec. 1202 only the amount of gain the partner or shareholder would have been allocated based on his or her ownership interest on the date the QSB stock was originally acquired by the passthrough entity.⁷⁰

Example 16: A acquired a 33% interest in Partnership ABC on Jan. 1, 2013. In May 2013, the partnership contributed $150,000 to X Co. in exchange for X Co. stock. In 2015, A increased his ownership in Partnership ABC from 33% to 50%. In 2019, at a time when the X Co. stock meets the definition of QSB stock, Partnership ABC sells all of the X Co. stock for $800,000, recognizing gain of $650,000, $325,000 of which is allocated toA.

Because (1) the X Co. stock was QSB stock in the hands of Partnership ABC, and (2) A was a partner in Partnership ABC from the time of its acquisition of the X Co. stock through the sale of the X Co. stock, A is eligible to exclude a portion of his $325,000 gain under Sec. 1202. A is limited, however, to taking into account under Sec. 1202 the amount of gain A would have been allocated based on his original interest in Partnership ABC, or 33%. Thus, A may take into account only $216,667 of gain under Sec. 1202(a). Because the applicable percentage for QSB stock acquired in 2013 is 100%, A may exclude the entire $216,667 of gain taken into account under Sec. 1202. A must include the remaining $108,333 of gain allocated from Partnership ABC in his income.⁷¹

QSB stock acquired via tax-free incorporation or reorganization

A shareholder may exchange QSB stock for stock in another corporation as part of a tax-free incorporation under Sec. 351 or a tax-free reorganization under Sec. 368. If the stock received in the transaction would not, on its own terms, meet the definition of QSB stock, the stock is nonetheless treated as QSB stock in the hands of the transferring shareholder because the stock that was exchanged was QSB stock.⁷² The holding period of the QSB stock received in the transaction begins on the date the exchanged stock was acquired; however, upon a subsequent disposition of the stock, only the appreciation inherent at the time of the original transfer may be taken into account under Sec. 1202.

Example 17: A transfers $10,000 to X Co. in exchange for stock on June 1, 2013. The stock meets the definition of QSB stock. On June 1, 2018, as part of a tax-free merger under Sec. 368(a)(1)(A), A exchanges his X Co. stock for stock in Y Co. with a value of $500,000. Y Co. stock would not otherwise meet the definition of QSB stock on June 1, 2018. Nonetheless, because A transferred QSB stock in the transaction, the Y Co. stock is treated as QSB stock in A’s hands. The acquisition date of the stock for purposes of the five-year holding period begins on June 1, 2013.

On July 1, 2020, A sells the Y Co. stock for $1 million. The amount of gain eligible for the Sec. 1202 exclusion is limited to the appreciation that was inherent in the X Co. stock at the time of the reorganization, or $490,000 ($500,000 value on June 1, 2018, less A’s $10,000 basis in the stock).

If the stock received by a transferring shareholder in an incorporation or reorganization would, on its own, meet the definition of QSB stock, the stock is treated as QSB stock in the hands of the transferring shareholder, the holding period of the QSB stock received in the transaction includes the period the shareholder held the transferred stock, and any subsequent appreciation in the QSB stock received in the transaction will be taken into account under Sec. 1202, assuming the requirements of Sec. 1202 continue to be met.

Example 18: The facts are the same as in the preceding example, except the Y Co. stock received by A in the transaction meets the definition of QSB stock. The Y Co. stock is treated as QSB stock in the hands of A, and A’s holding period in the A stock begins on June 1, 2013. Upon A’s sale of the stock for $1 million on July 1, 2023, the entire gain of $990,000 (comprised of pretransaction appreciation of $490,000 and post-transaction appreciation of $500,000) is taken into account under Sec. 1202 and is eligible for a 100% exclusion.

Impact of the new tax law

With the TCJA reducing the corporate tax rate to 21% and Sec. 1202 offering a 100% exclusion upon the sale of QSB stock, should every business be established as a C corporation?

The answer, of course, is that there are no absolutes in the tax law, and taxpayers must continue to approach the proper entity choice for their business on a case-by-case basis. After all, as opposed to a shareholder in a C corporation, the owner of a sole proprietorship, partnership, or S corporation continues to be subject to only a single level of tax, at the owner level. The TCJA reduced the top individual rate to 37%, before also enacting new Sec. 199A, which allows the owner of a qualifying passthrough business to deduct 20% of the income earned by the entity, further reducing the top rate on passthrough income to 29.6%. Comparatively, the imposition of double taxation on C corporation income amounts to an effective tax rate as high as 39.8%,⁷³ meaning that doing business as a passthrough continues to offer a sizable tax advantage relative to a C corporation.

If a business can be structured so as to qualify for the benefit of Sec. 1202, however, a business owner may be content to lose the battle by paying more tax on a year-to-year basis, if it means he or she can win the war upon exit by excluding all of the gain under Sec. 1202.

Example 19: A is planning to form a new technology businessin which he will invest $100,000. Based on A’s projections, the business will earn $200,000 in net income in each of the next five years, which A will withdraw from the business in full as a distribution. After five years, A believes the business will be worth $3 million. Assume that, as the owner of a passthrough business, A would qualify for a full Sec. 199A deduction and that the stock in the corporation would meet the definition of QSB stock. The federal tax consequences over the full life cycle of each business option would be as shown in the table “Taxation as Passthrough vs. C Corporation.”

Based on this simplistic example, the Sec. 1202 exclusion allows A to save nearly $500,000 as a C corporation despite incurring double taxation on operating income. Many tax and nontax factors must be taken into consideration in choosing an entity, but opting for a C corporation and potential Sec. 1202 benefits will make sense when:

• A minimum five-year holding period is realistic.
• Future investors into the business will be able to take advantage of Sec. 1202 (noncorporate investors).
• The expected appreciation in the value of the corporate stock is enough to overcome the effect of double taxation on operating income.
• Shareholders are willing to retain some earnings in the corporation to minimize the effect of double taxation.
• Based on the nature of the business, the active business requirement and gross-assets test will not be problematic.

Interplay of Sec. 1202 with Sec. 199A

The 20% deduction offered by Sec. 199A to owners of passthrough businesses was designed to allow those owners to keep pace with the tax cuts offered to their corporate counterparts. Sec. 199A, however, is rife with limitations, exceptions to limitations, phase-ins and phaseouts, and critical but poorly defined terms of art that make its application far from clear and thus its benefits far from guaranteed.

Interestingly, an owner who feels compelled to do business as a C corporation because he or she will not qualify for the benefits of Sec. 199A will find that in most cases, if a Sec. 199A deduction is not available, neither is a Sec. 1202 exclusion.

Sec. 199A provides that for business owners with taxable income in excess of a threshold,⁷⁵ no deduction is permitted against income earned in a “specified service business.” A specified service business, for purposes of Sec. 199A, is defined by reference to Sec. 1202(e)(3)(A), which includes among those businesses ineligible for Sec. 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 1 or more of its employees.⁷⁶

Thus, if the high-income owner of a service business who would be denied a deduction under Sec. 199A opts instead to operate as a C corporation, no Sec. 1202 exclusion will be available upon a future sale of the corporation’s stock.

Conversions of an existing business

It is anticipated that the combination of a 21% corporate rate and the unavailability of the Sec. 199A deduction to certain passthrough businesses will cause many passthrough businesses to convert to C corporations, with a recent simulation by Penn Wharton predicting that 235,780 business owners will make the switch.⁷⁷ While it is anticipated that the majority of those businesses will be service businesses that are ineligible for the benefits of both Sec. 199A and Sec. 1202, other converting businesses will do so with an eye toward a future Sec. 1202 exclusion. In these cases, care must be given to the nature of the conversion.

S corporation to C corporation

As discussed earlier in this article, for stock to meet the definition of QSB stock, the issuing corporation must be a C corporation on the date of issuance. Thus, if an S corporation that otherwise meets all the requirements of a qualified small business under Sec. 1202 issues stock, that stock can never qualify as QSB stock, even if the S corporation later converts to a C corporation.

Example 20: In 2016, A and B form X Co., an S corporation, by transferring $1,000 each to the corporation in exchange for stock. The corporation meets all the requirements of Sec. 1202 except that the corporation is an S corporation, not a C corporation. Effective Jan. 1, 2019, X Co. revokes its S election. The stock held by A and B cannot qualify as QSB stock, because at the time the stock was issued, the corporation was not a C corporation.

Thus, if the S corporation revokes or terminates its election, it will need to issue new shares of stock while meeting all of the requirements of Sec. 1202, for the issued stock to meet the QSB stock requirements.

Example 21: Continuing the previous example, assume that in January 2019, A and B contribute $1,000 each to X Co., now a C corporation, in exchange for shares. If X Co. satisfies the other requirements of Sec. 1202, the stock issued in 2019 will qualify as QSB stock. Thus, if A and B hold the stock for five years, they will be eligible for a 100% exclusion on any resulting gain, subject to the lifetime and annual exclusions.

Partnership to C corporation

Rev. Rul. 84-111 provides three methods for an existing partnership to convert to a C corporation. Each method allows the partners-turned-shareholders to qualify for the benefits of Sec. 1202.

Using the “assets up” method, the partnership distributes its assets in liquidation to its partners, who then transfer the assets to a newly formed corporation in exchange for stock in a Sec. 351 transaction. In this scenario, the stock the partners receive is received at original issuance. As discussed earlier in this article, however, the holding period of the stock will begin on the date of the transfer, and the partner’s basis in the stock will be the FMV of the assets transferred to the corporation.⁷⁸ As a result, only appreciation occurring after the incorporation will be eligible to be excluded under Sec. 1202.

Using the “interests over” method, the partners transfer their respective partnership interests to a newly formed corporation in exchange for stock in a Sec. 351 transaction. The consequences are the same as in the “assets up” method.

Using the “assets over” method — the default method for a conversion — the partnership transfers its assets to a newly formed corporation in a Sec. 351 transaction, followed by a liquidation of the partnership. In this scenario, the stock is momentarily held by the partnership prior to the partnership’s liquidation, causing some to speculate that because the original owner of the stock is the partnership, rather than the partners, the stock was not acquired at “original issuance” by the partners. As discussed earlier in this article, however, Sec. 1202(h)(2)(C) provides that when a partnership distributes stock to a partner, the partner is treated as having acquired the stock in the same manner as the partnership, provided the partner was a partner in the partnership from the partnership’s acquisition of the stock through the date of distribution. Because in the “assets over” method the incorporation and liquidation happen simultaneously, the partner will satisfy all requirements and will be treated as having received the stock at original issuance. As with the other two scenarios, the partner’s holding period in the stock will begin on the date of the liquidation, and the basis in the stock will be the partner’s share of the FMV of the assets transferred to the corporation by the partnership. As a result, only future appreciation accruing after the date of conversion will be eligible for Sec. 1202.

It is important to note that as discussed previously in this article, for purposes of measuring the $50 million gross-assets test on the date of a partnership conversion, the basis of the assets of the corporation is treated as not less than their FMV. This could cause a partnership with substantial intangible value to fail the gross-assets test and preclude the stock received by the converting partners from qualifying as QSB stock.

The advantages of C corporations and QSB stock

The confluence of a 21% corporate rate and the 100% Sec. 1202 exclusion could well usher in a golden era of C corporations. All tax and nontax factors must be taken into consideration, but once the decision has been made to operate as a C corporation, business owners and their tax advisers will need to be proactive in taking the steps necessary to ensure the stock meets the definition of QSB stock; from testing the gross adjusted basis of assets upon the issuance of shares, to valuing, measuring, and documenting the value of assets annually for purposes of the active business requirement, to analyzing the effect of any corporate redemptions.  

Footnotes

¹P.L. 115-97.

²When the corporation distributes its income to a shareholder as a dividend, the shareholder pays tax on the dividend at a top rate of 23.8%. This results in a combined effective federal tax rate on income earned by a C corporation of 39.8% (21% + ([1 – 21%] × 23.8)).

³Sec. 1202(a)(1). A sibling provision, Sec. 1045, allows a noncorporate shareholder to defer gain on the sale of QSB stock held for more than six months. For the purposes of Sec. 1045, QSB stock is defined in the same manner as it is for Sec. 1202.

⁴Sec. 1202(a)(3).

⁵Sec. 1202(a)(4).

⁶Section 13113(a), P.L. 103-66.

⁷Section 311(a), P.L. 105-34.

⁸50% includible gain multiplied by a 28% tax rate. In addition, 7% of the excluded gain was also treated as an addition to the shareholder’s alternative minimum taxable income.

⁹Jobs and Growth Tax Relief Reconciliation Act of 2003, P.L. 108-27.

¹⁰Originally, the 100% exclusion was temporary, but it was made permanent by the Protecting Americans From Tax Hikes Act of 2015, P.L. 114-113.

¹¹Sec. 1202(c)(1).

¹²Sec. 1202(c)(1)(A).

¹³Sec. 1202(d)(1)(A).

¹⁴Sec. 1202(d)(1)(B).

¹⁵Sec. 1202(d)(1)(C).

¹⁶Sec. 1202(d)(2).

¹⁷Sec. 1202(d)(2)(B). This is contrary to the general rules of Sec. 362, which provide that when a shareholder contributes appreciated property to a corporation in a Sec. 351 transfer, the basis of the property in the corporation’s hands is the same as the property’s basis in the hands of the transferor, increased by any gain the transferor recognized.

¹⁸Sec. 1202(i).

¹⁹Sec. 1202(d)(3). A parent-subsidiary controlled group is defined in Sec. 1563(a)(1) except that “more than 50%” is substituted for “at least 80%” each place it appears in Sec. 1563.

²⁰Sec. 1202(c)(1)(B).

²¹H.R. Conf. Rep’t No. 103-213, 103d Cong. 1st Sess., p. 526 (Aug. 4, 1993).

²²Sec. 1202(h)(1)(A).

²³Sec. 1202(h)(2)(C) and Secs. 1202(g)(2) and (3).

²⁴Sec. 1202(i)(1)(A). The holding period rule for property contributions is contrary to the general rule of Sec. 1223, which generally allows, in the case of a transfer meeting the requirements of Sec. 351, a transferor shareholder to include in the holding period of stock received by a corporation the period of time any property transferred to the corporation was held by the shareholder.

²⁵Thus, if a taxpayer receives unrestricted stock in exchange for services, the value of which is immediately included in the taxpayer’s income, the issuance date is the date of receipt. If the stock is nontransferable and subject to a substantial risk of forfeiture, however, the issuance date is the first date on which the stock becomes either transferable or no longer subject to a substantial risk of forfeiture, and the value of the stock is included in the taxpayer’s income under Sec. 83. Finally, if a taxpayer receives restricted stock and makes a Sec. 83(b) election to accelerate the inclusion of income from the stock, the issuance date will be the date of the election.

²⁶H.R. Conf. Rep’t No. 103-213, 103d Cong. 1st Sess., p. 526 (Aug. 4, 1993).

²⁷Id. Because of this rule, if a corporation is a target in a tax-free reorganization, a taxpayer who owns an option to acquire stock in the target corporation that would qualify as QSB stock (without regard to the five-year holding period) should consider exercising the option prior to the transaction so that the stock received in the transaction will also qualify as QSB stock. See the discussion in the article concerning an exchange of QSB stock in a reorganization.

²⁸Sec. 1202(f).

²⁹Sec. 1202(h)(1)(B).

³⁰Sec. 1202(i)(1)(B).

³¹As discussed later in this article, however, when applying the annual limitation of Sec. 1202(b)(1)(B), the adjusted basis of any stock sold during the year is determined without regard to any addition to basis after the date on which the stock was originally issued.

³²Rev. Proc. 77-37.

³³First National Bank of Altoona,104 F.2d 865 (3d Cir. 1939).

³⁴Arctic Ice Machine Co.,23 B.T.A. 1223 (1931).

³⁵Sec. 1202(c)(2)(A). This “substantially all” requirement leaves open the possibility that a brief period — perhaps less than 20% of the total life of the corporation — as an S corporation will not preclude stock in the corporation from meeting the definition of QSB stock, provided that the stock was issued while the corporation was a C corporation.

³⁶Sec. 1202(e)(1). This requirement is waived for a corporation that is a specialized small business investment company (SSBIC). An SSBIC is any eligible corporation (under the meaning of Sec. 1202(e)(4)) that is licensed to operate under Section 301(d) of the Small Business Investment Act of 1957 (as in effect on May 13, 1993). See Sec. 1202(c)(2)(B).

³⁷Sec. 1202(e)(1)(B).

³⁸Sec. 1202(e)(4).

³⁹Sec. 1202(e)(3).

⁴⁰See also IRS Letter Ruling 201717010. In the ruling, the IRS concluded that a business that performed and analyzed medical tests using patented technology and prepared laboratory reports for health providers was not itself performing services in the field of health. The IRS reached its conclusion, in part, because the taxpayer did not explain test results to patients or recommend treatment.

⁴¹Owen,T.C. Memo. 2012-21 (2012).

⁴²See also IRS Letter Ruling 201717010, in which the IRS concluded that the principal asset of a business that performed and analyzed medical tests using patented technology, and prepared laboratory reports for health providers, was not its employees, because the skills employees brought to the taxpayer were not useful in performing the tests, and the skills they developed while working for the taxpayer were not useful to other employers.

⁴³For these purposes, rights to computer software that produces active business computer software royalties (within the meaning of Sec. 543(d)(1)) are treated as an asset used in the active conduct of a trade or business.

⁴⁴Sec. 1202(e)(2).

⁴⁵These activities include any amount paid or incurred in connection with investigating the creation or acquisition of an active trade or business, or creating an active trade or business, or any activity engaged in for profit and for the production of income before the day on which the active trade or business begins, in anticipation of such activity becoming an active trade or business.

⁴⁶For these purposes, the corporation must own at least 50% of the combined voting power of all classes of stock entitled to vote, or more than 50% in value of all outstanding stock of the subsidiary corporation.

⁴⁷Sec. 1202(e)(5)(A).

⁴⁸Sec. 1202(e)(5)(B).

⁴⁹Sec. 1202(e)(7).

⁵⁰139 Cong. Reg. S10732 (Aug. 6, 1993).

⁵¹Bardahl Mfg. Corp., T.C. Memo. 1965-200.

⁵²The IRS has stated its position that for service businesses that do not produce, purchase, and sell inventory, the operating cycle should consider the average length of time required to perform on a contract (Internal Revenue Manual §4.10.13.2.5.1.3 (3/16/15)).

⁵³Failing the 80% test is only relevant in the context of “substantially all” of a shareholder’s holding period. For those shareholders who received stock in 2015, this is the first time the corporation failed the test, and so their stock should not yet be tainted. For those shareholders who receive stock in the 2018 financing round, however, they have begun their holding period at a time when the corporation fails the 80% test. Thus, for the stock issued in 2018 to eventually qualify as QSB stock, the corporation would have to change the composition of its assets in a way that satisfies the test, and then continue to satisfy the test for substantially all of the holding period of the new shareholders.

⁵⁴For these purposes, the acquisition date is the first day on which the stock is treated as held by the shareholder under Sec. 1223, which generally provides for a tacked holding period when stock is acquired in certain tax-free exchanges.

⁵⁵Note, however, that this rule does not change the rule found in Sec. 1202(i)(1), discussed in this article, which provides that when a shareholder transfers property to a corporation in exchange for stock in a Sec. 351 transfer, the holding period of the stock for Sec. 1202 purposes is the date of the transfer, despite the fact that for regular tax purposes, Sec. 1223 would provide for a tacked holding period.

⁵⁶Sec. 1202(a)(4)(C).

⁵⁷Sec. 1202(b)(1)(A). In the case of married taxpayers filing separately, the $10 million cumulative limitation is reduced to $5 million. See Sec. 1202(b)(3).

⁵⁸Sec. 1202(b)(1)(B). For these purposes, the adjusted basis of any stock is determined without regard to any addition to basis after the date on which the stock was originally issued.

⁵⁹Note, however, that this gain recognized by virtue of the application of the limitations is not subject to the 28% rate under Sec. 1(h)(7).

⁶⁰Sec. 1(h)(7).

⁶¹Sec. 331.

⁶²Note, however, that if the redemption is significant, it might disqualify stock issued by the corporation from the definition of QSB stock. See the discussion on redemptions in this article.

⁶³Sec. 1202(c)(3)(A); Regs. Sec. 1.1202-2(a). For these purposes, a related party is any person related within the meaning of Sec. 267(b) or 707(b).

⁶⁴Regs. Sec. 1.1202-2(a)(2).

⁶⁵Sec. 1202(c)(3)(B).

⁶⁶Or a regulated investment company or common trust fund.

⁶⁷Sec. 1202(g)(1).

⁶⁸Sec. 1202(g)(2)(A).

⁶⁹Sec. 1202(g)(2)(B).

⁷⁰In applying the cumulative and annual limitations, the partner or shareholder is treated as having a basis in the shares of QSB stock sold by the passthrough entity equal to the partner or shareholder’s interest in the partnership.

⁷¹Also note, for purposes of applying the cumulative and annual limitations, A’s basis in the X Co. stock is deemed to be $75,000 (50% of $150,000).

⁷²Sec. 1202(h)(4)(A).

⁷³21% + ([1 – 21%] × 23.8%)).

⁷⁴$1 million of cumulative income less $210,000 of federal income tax.

⁷⁵$315,000 (for married taxpayers filing jointly; $157,500 in the case of all other taxpayers).

⁷⁶Sec. 199A then amends this definition by removing engineering and architecture and substituting “employees or owners” for “employees.”

⁷⁷Penn Wharton Budget Model, “Projecting the Mass Conversion From Pass-Through Entities to C-Corporations” (6/12/18), available at budgetmodel.wharton.upenn.edu.

⁷⁸Sec. 1202(i)(1).

	Contributor
	Tony Nitti, CPA, MST, is a partner with WithumSmith+Brown in Aspen, Colo. For more information about this column, contact thetaxadviser@aicpa.org.