The combination of the 21% tax rate created by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, and the 100% gain exclusion provided in Sec. 1202 has made organizing a business as a C corporation more beneficial than it has been in decades. With the increasing interest in the 100% exclusion, a number of issues have arisen in determining whether and to what extent corporate stock qualifies for the Sec. 1202 exclusion. This item discusses issues relating to property contributions to a corporation without the issuance of shares and whether these contributions result in deemed issuances of stock for purposes of Sec. 1202.
Significant provisions of Sec. 1202
For noncorporate taxpayers, 100% of the gain realized on the sale or exchange of qualified small business stock (QSBS) acquired after Sept. 27, 2010, and held by the taxpayer for more than five years is excluded from gross income, subject to a limitation discussed below (Sec. 1202(a)(4)). For gain realized on the sale of stock acquired on or before Sept. 27, 2010, a percentage is excluded, depending on the date of acquisition (Secs. 1202(a)(1) and (3)).
The amount of gain a taxpayer is eligible to exclude in any tax year is subject to a limitation, which is generally the greater of: (1) $10 million; or (2) 10 times the aggregate adjusted bases of the QSBS disposed of by the taxpayer in the tax year (Sec. 1202(b)). For stock held by a passthrough entity, the limitation is computed on a partner/shareholder-level basis and not an entity-level basis (Sec. 1202(g)). The taxpayer must have acquired the stock directly (or through an underwriter) from the issuing corporation, and the corporation must have originally issued the stock after Aug. 10, 1993 (Sec. 1202(c)). The issuer corporation must remain a domestic C corporation during substantially all of the taxpayer's holding period (Secs. 1202(c)(2) and (e)(4)).
One of the requirements of Sec. 1202, and the focus of this discussion, is that the issuing corporation must be a qualified small business (QSB) as of the date of issuance and immediately after the issuance (including amounts received in the issuance) (Sec. 1202(c)(1)). To satisfy the QSB requirement, the aggregate gross assets of the corporation — cash and the adjusted tax bases of property held by the corporation — must not have exceeded $50 million at all times prior to the stock issuance, and where property is contributed to the corporation, the fair market value is deemed the adjusted basis (Sec. 1202(d)). This discussion focuses on the QSB requirement and the five-year holding period where contributions are made without an issuance of stock.
Treatment of contributions to capital
Where a shareholder makes an initial capital contribution to a wholly owned corporation in exchange for its stock and makes no further contributions, the application of the QSB requirement is straightforward. Where, however, the shareholder makes successive post-acquisition contributions to the corporation but receives no additional shares in exchange, satisfaction of the QSB requirement is not so clear.
Do such contributions result in deemed issuances of stock for purposes of Sec. 1202, requiring a new five-year holding period, and does the corporation have to satisfy the QSB $50 million asset requirement as of, and immediately after, the contribution? If yes, then it would appear that a taxpayer may need to bifurcate his or her shares for Sec. 1202 purposes under a deemed recapitalization approach, as described below, and test each bifurcation separately. The following examples illustrate these questions (assuming all other Sec. 1202 requirements are met):
Example 1: J incorporates ABC Corp. in 2019 and contributes $30 million in exchange for 100% of the shares of ABC Corp. In 2022, J contributes an additional $10 million to ABC Corp. and receives nothing in exchange. The value of ABC Corp.'s aggregate gross assets after the contribution is $40 million. J sells the stock in 2030. Here, whether a deemed exchange occurred appears irrelevant for the holding period requirement, as all stock was issued while ABC Corp. was a QSB, and all the stock met the five-year holding period requirement. Note that the treatment may become relevant for gain exclusion purposes as Sec. 1202(b)(1)(B) limits the 10-times-aggregate-basis exclusion to the original issued basis in the stock.
Example 2: Instead, J sells the stock in 2025 — not in 2030. Can J exclude 100% of the gain on the sale, subject to the per-issuer limitation, or must he treat a portion of the gain as allocable to the $10 million he contributed in 2022, for which the five-year holding period requirement has not been satisfied?
Example 3: Alternatively, in 2022, the value of ABC Corp. is $70 million, and J contributes an additional $70 million, thereby increasing the value of ABC Corp.'s aggregate gross assets far beyond $50 million. J sells the stock in 2030. Can J treat the entire gain as eligible for the 100% exclusion, subject to the per-issuer limitation, or did a deemed exchange and issuance of 50% of ABC Corp. stock occur in 2022, with the result that 50% of the stock is ineligible for the exclusion?
Sec. 351 and the meaningless-gesture doctrine
At first glance, the reader may wonder why there is any concern, as the transactions appear to represent contributions and not Sec. 351 transfers. To qualify as a Sec. 351 exchange, the transferor must receive transferee stock in exchange for the property and must satisfy the control requirement. Where the transferor shareholder already owns 100% of the transferee, the control requirement is a nonissue; however, the exchange requirement does not appear satisfied upon a mere contribution of property.
The concern lies in the "meaningless-gesture" doctrine, which generally holds that issuance of additional shares is not required to satisfy the exchange requirement where the issuance would be meaningless due to the contributor's existing ownership. In the context of a contribution by a single shareholder to a wholly owned corporation, the issuance of shares does not appear to serve a particular purpose. Accordingly, both the IRS and courts have held that an actual issuance is not required to satisfy the exchange requirement of Sec. 351.
In Rev. Rul. 64-155, the IRS held that the transfer of a wholly owned foreign corporation to the shareholder's wholly owned domestic corporation represented a Sec. 351 transfer despite no actual issuance of shares. This ruling appeared to involve the intentional avoidance of gain recognition under Sec. 367, where the decision not to issue shares was tax-motivated. But the courts have also applied the meaningless-gesture doctrine in a situation not involving the avoidance of gain recognition and held that a Sec. 351 transfer occurred when the taxpayer transferred assets and the corporation assumed liabilities without an actual issuance of shares (see, e.g., Lessinger, 85 T.C. 824 (1985), citing Morgan, 288 F.2d 676 (3d Cir. 1961); but see Abegg, 50 T.C. 145 (1968), aff'd, 429 F.2d 1209 (2d Cir. 1970)). However, none of the authorities appear to address whether a deemed issuance occurs but simply hold that the exchange requirement of Sec. 351 was met.
As with Sec. 351, the courts and the IRS have applied the doctrine in the context of Sec. 368(a)(1)(D) (D reorganizations), holding that an actual issuance of shares is not necessary where the issuance would represent a meaningless gesture (see James Armour, Inc., 43 T.C. 295, 307 (1964); Wilson, 46 T.C. 334 (1966); and Rev. Rul. 70-240). In final regulations issued in 2009, Treasury adopted rules for applying the doctrine to D reorganizations, providing that a stock issuance is not required where both the transferor and transferee corporations have identical stock ownership (Regs. Sec. 1.368-2(l), T.D. 9475).
Regulations addressing 'no-consideration' transfers
Final regulations address the nonissuance of stock in the context of a no-consideration D reorganization and provide for a deemed exchange of shares followed by a recapitalization (Regs. Secs. 1.358-2(a)(2)(iii)(A)(2) and (B)).
Proposed regulations issued in 2009 but never finalized address Sec. 351 transfers with no issuance of stock and provide for the following deemed steps: (1) the corporation issues deemed shares equal to the fair market value of the property transferred to the corporation, and (2) the actual and deemed shares are exchanged in a Sec. 368(a)(1)(E) reorganization for the actual shares (Prop. Regs. Sec. 1.358-2(g)(3); REG-143686-07). With respect to the holding period of the deemed shares received and recapitalized in a deemed recapitalization, the shares would likely take a split holding period based upon the proportionate value of the shares deemed received and the shares held before the contribution (see Rev. Rul. 85-164).
Application to Sec. 1202 examples
Based upon the above analysis, it would appear that a shareholder's capital contribution to his or her wholly owned corporation could represent a Sec. 351 transfer. Accordingly, if the proposed regulations' deemed transactions were to apply, the contributions in the above examples would represent stock issuances for Sec. 1202 purposes, with the following results:
Example 1 answer: The facts in this example are quite clean, as both the original issuance and deemed issuance occurred more than five years earlier, and ABC Corp. met the QSB asset threshold at each date.
Example 2 answer: Based upon the deemed issuance date of 2022 for 25% of the stock value ($10 million contribution of $40 million post-contribution value), it would appear that only 75% of the gain would qualify for the 100% exclusion, as the remaining 25% would not meet the five-year holding period.
Example 3 answer: Based upon the deemed issuance date of 2022 for 50% of the stock value ($70 million contributed of $140 million post-contribution value), it would appear that only 50% of the gain would qualify for the 100% exclusion, as ABC Corp. would not meet the $50 million QSB requirement either before or after the contribution.
The meaningless-gesture doctrine does not necessarily create a stock issuance for purposes of Sec. 1202. As noted above, the case law and ruling history of Sec. 351 do not create a deemed issuance, and the regulations creating a deemed issuance and recapitalization are still in proposed form. Perhaps the doctrine merely operates to satisfy the exchange requirement but not to create an otherwise nonexistent stock issuance.
Moreover, one could distinguish between the case law and rulings cited, on the one hand, and the above examples, on the other. In Rev. Rul. 64-155 and Lessinger, the property contributed was noncash built-in gain or loss property. In the examples, the property contributed was cash. Perhaps, in contrast to a transfer of appreciated property, a transfer of cash is properly treated as a mere contribution of capital and not as a deemed issuance of stock, since Sec. 351 is irrelevant, as the contribution of cash does not generate gain. This seems in line with Sec. 1202(b)(1)(B). (But see Technical Advice Memorandum 9830002, where the IRS appears to suggest applying the meaningless-gesture doctrine even regarding the cancellation of debt, which is generally treated similarly to the transfer of cash.) It is also important to note Sec. 1202(i)(2) contemplates a contribution of built-in gain property to a corporation without a stock issuance, which seems to support that the meaningless-gesture doctrine would not necessarily be a default position.
However, even if one were to accept one of these arguments, in a case in which a shareholder would have taken back additional stock but for the motivation of enabling Sec. 1202 treatment, the substance-over-form doctrine would likely recast the contribution as a deemed issuance of stock, which appears consistent with Rev. Rul. 64-155.
A dearth of guidance
Despite increased interest in Sec. 1202, there is little authoritative guidance directly addressing a number of critical areas, one of which is the treatment of contributions, potentially resulting in deemed exchanges. Based upon existing authorities, there is a risk that the meaningless-gesture doctrine would apply to such contributions, thereby subjecting the transfers to Sec. 351. It appears less clear whether a deemed issuance and recapitalization will occur for purposes of Sec. 1202, but taxpayers and advisers should be wary of this risk. Ultimately, this issue needs further guidance, and, until such guidance is issued, taxpayers should consult with qualified tax professionals when assessing the treatment of such contributions.
Mo Bell-Jacobs, J.D., is a manager, Washington National Tax for RSM US LLP.
Contributors are members of or associated with RSM US LLP.